Economy

Highlights The investors we met last week were ready to hear some good news: The constructive story we told across three days of client meetings is more sanguine than the consensus view, but clients were open to considering it. Global economic weakness and the elevated risk of a U.S. recession were primary concerns, … : As our Global Investment Strategy colleagues have suggested, it will take some time for investors to be convinced that global manufacturing really has seen the bottom and that the U.S. isn’t flirting with a recession. … followed by trade tensions and corporate indebtedness, … : Our small sample suggests that investors may have become de-sensitized to the daily ebb and flow of the U.S.-China conflict, though we continue to believe it looms large in the minds of corporate managements. … but nothing matches the anxiety provoked by Elizabeth Warren’s ascent: Every client asked about the potential consequences of a Warren White House. Feature We spent most of last week meeting with a subset of wealth management and family office clients. They are more focused on absolute returns than relative returns, but their primary concerns are nearly identical to their relative-return peers’. Our meetings touched on a broad constellation of questions about the fate of the expansion, the equity bull market, global growth and the U.S.-China trade negotiations. Clients also asked about the credit outlook and if inflation should be on their radar, but the topic that they raised with the most fervor, in every single one of our meetings, was the prospect of a Warren or Sanders presidency. Q: What is the bond market telling us? We think of the bond market as having two distinct components, rates (Treasuries) and credit (spread product). We have gotten used to regular retracements in the 10-year Treasury yield since it bottomed in July 2016, but watching it melt from 3.25% last November to 1.5% this August has challenged our constructive take on the U.S. economy. Falling yields are not necessarily signaling imminent economic trouble, however, so we continue to hold the view that a recession won’t occur before late 2021 or early 2022. We see this year’s falling Treasury yields as a coincident reflection of decelerating growth, not a harbinger of a recession. On a purely domestic basis, the principal driver of the decline in yields has been the shift in monetary policy expectations. The Fed’s dovish pivot did not occur in a vacuum, of course. Clear signs of decelerating growth set the stage for easier policy, both here and abroad. Whether or not the Fed was always calling the tune, all three step-function declines in 12-month forward fed funds rate expectations occurred as it was guiding markets to expect easier policy: ahead of the March FOMC meeting, when Fed speakers began warning of the danger of inflation expectations becoming unanchored on the downside; in May, when they were busily preparing the ground for a rate cut; and after the July meeting raised the prospect that the July cut would not be a one-off event (Chart 1). Chart 1The Fed's Dovish Pivot, ... Sovereign rates are not entirely determined domestically, and much of the softness in Treasury yields reflects the softness in yields in the rest of the world. So far this year, 10-year sovereign yields have moved in lockstep on either side of the Atlantic (Chart 2), preserving no-arbitrage conditions in currency-hedged Treasuries, gilts and bunds. Crude prices are another global variable, and their decline has weighed on inflation break-even rates (Chart 3), dampening the inflation compensation demanded by Treasury buyers. From a rates perspective, we think the bond market is telling us that global growth has slowed, central banks have taken monetary accommodation up a notch, and oil prices have slid. That’s not exactly an ideal growth backdrop, but it hardly spells the end of the expansion. Chart 2... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower The credit market concurs. It doesn’t betray a whit of concern that the expansion is in trouble. Spreads quickly unwound last year’s fourth-quarter spike, and have since hung around their post-crisis lows (Chart 4). Non-financial corporations have become more indebted throughout the expansion, but servicing the debt is not at all onerous with yields at rock-bottom levels (Chart 5). Our U.S. Bond Strategy service’s proprietary corporate health monitor is signaling that corporate balance sheets have weakened (Chart 6, third panel), but the other elements required for a meaningful widening of spreads – a completed monetary tightening cycle1 (Chart 6, second panel), and a tightening of lending standards (Chart 6, bottom panel) – are not yet in place. Chart 3Falling Oil Prices Have Smothered Inflation Worries Chart 4Spreads Are Tight, ...   Chart 5... And Debt Service Is Easy Q: Isn’t it time to reduce credit exposures? Tight spreads may be a contrarian warning sign. Though it is sensible to shift some of a company’s financing burden to debt when it is so much cheaper than equity, combining a larger debt burden with degraded covenant protections is a concern. Low interest rates will keep debt service costs from chafing, and help keep defaults in check for now, but the bond market is increasingly vulnerable. Chart 6Spread Widening Conditions Aren't Yet In Place Chart 7Income Investors Need Not Apply Despite that vulnerability, when the next default cycle arrives, it will not have anywhere near the impact of the housing bust because it will deal no more than a glancing blow to the banks. Single-family homes collateralize the American banking system; corporate bonds are held by a diffuse assortment of unlevered players. It stinks for any unlevered investor when it loses money, but it doesn’t cause much of a ripple in the overall economy. Today’s buildup in corporate borrowing is not analogous to 2006-7’s residential mortgage Superfund site, and suggestions to the contrary are ill-founded. Elevated corporate leverage is a vulnerability, but it is not enough for an investor to identify a vulnerability; s/he also has to identify the catalyst that will cause it to snap. Nonfinancial corporate debt levels are a fissure that has been made longer by debauched covenants. Markets won’t suffer until the fissure lengthens and widens enough to turn into a crack that no investor can ignore. It is our view that easy monetary conditions will keep the fissure out of sight and out of mind for several months at least. Defaults only occur when a borrower is unable to refinance its maturing obligations. As long as there is at least one lender willing to extend new credit at manageable terms, the borrower won’t go bust. The current monetary policy backdrop, featuring zero/negative interest rate policy in much of the major economies, all but ensures a steady supply of willing lenders. Life insurers, pension funds and endowments with a need for income to offset fixed liabilities have been forced out the risk curve to source income sufficient to meet them (Chart 7). The net result has been to provide even wobbly credits offering an incremental 50 or 75 basis points with a line of would-be lenders out the door and around the corner. The global manufacturing sector has already succumbed to recession, but stout performance in the service sector has allowed developed economies to keep expanding. The weakest credits will not find lifelines, but plenty of dubious ones will. The current ultra-loose monetary policy environment is simply not a backdrop in which defaults pick up in earnest. Until central banks get a little less prodigal, the marginal lender won’t become more selective, the plates will keep spinning, and spread product will continue to generate excess returns over cash and Treasuries. Q: Things look worse outside the U.S. What’s your global growth outlook? Chart 8Manufacturing May Be Bottoming, ... The global manufacturing sector is in recession, but the overall global economy is not (Chart 8). A manufacturing recession does not necessarily lead to a full-blown recession, and the ongoing expansion in developed economies’ much larger service sector provides a formidable bulwark against manufacturing’s struggles (Chart 9). While it is too early to conclude if or when global activity will accelerate, our global leading economic indicator, and the diffusion index that leads it, suggest that it is in the process of bottoming (Chart 10). Chart 9... And Services May Have Stopped Decelerating ... Chart 10... If Leading Indicators Have Found A Footing Chart 11From Headwind To Tailwind Our China Investment Strategy team sees scope for Chinese growth to gather some steam in the first quarter of 2020, when local governments will be freed from the budget constraints imposed by Beijing through the end of this year. In the meantime, September money and credit growth topped expectations, and policymakers have been undertaking modest stimulus measures like trimming bank reserve requirement ratios. Changes in Chinese credit growth lead changes in global growth (Chart 11), via China’s credit-reliant import channel. Its imports are Europe’s, Japan’s, Asian EMs’, and Australia’s, Brazil’s and Chile’s exports. As their exports rise, so too does their aggregate demand, giving rise to a self-reinforcing virtuous circle. Q: What would President Warren mean for markets? Investors’ concerns about a Warren presidency are surely justified; Senator Warren has openly, and often gleefully, expressed hostility for banks, defense contractors, drug companies, oil companies engaged in fracking, and big tech. That’s quite a list, and it accounts for a considerable share of S&P 500 market capitalization. It is fair to say that a Warren administration would be unfriendly to equity investors, but there are several points to keep in mind before liquidating one’s portfolio and fleeing the country. It’s too early to award her the Democratic nomination. In October 2007, the smart money was certain that Hillary Clinton had already locked up a berth in the finals against the eventual Republican nominee. Very few Americans could have named the freshman senator from Illinois, known for little more than a well-received speech at the 2004 convention, but he became President Obama. A lot could still happen between now and the Iowa caucuses on February 3rd. Unseating an incumbent president is a tall order. As long as the economy does not enter a recession between now and next November, and the administration can achieve a policy victory without suffering a high-profile policy failure, our Geopolitical Strategy colleagues argue that Trump should be the presumed winner of the 2020 election. Their presumption applies no matter who captures the Democratic nomination, even as the U.S. electorate is shifting to the left over time (Chart 12). Transforming Washington is easier said than done. The framers designed the federal government to be fairly resistant to sweeping change. The Electoral College tamps down popular passions in the presidential election, and Congress and the courts limit the power of the executive branch. Administrations with majorities in the House and Senate routinely find themselves with less freedom than they would like, especially after they exhaust political capital achieving one major legislative initiative (as with the Obama Administration and the Affordable Care Act). Even if the Democrats ride President Warren’s coattails to control over Capitol Hill next November, legislators from conservative or swing districts and states will balk at her entire suite of proposals. Chart 12Democratic Voters Are Leaning More Left Investment Implications Our sunnier view of the global economic outlook translates into more constructive equity allocations across global regions and blocs. The BCA house view recommends equal weight allocations to Emerging Markets and the Eurozone within global equity portfolios across tactical (0-3-month) and cyclical (3-12-month) timeframes. We expect to upgrade EM and Eurozone equities to overweight, and downgrade U.S. equities from overweight, across those timeframes once global growth begins to accelerate. We would also favor higher-beta currencies versus the dollar, and limit or avoid exposure to lower-beta currencies like the yen or the Swiss franc, if the data are poised to validate our base-case growth scenario. BCA’s recommendations have become especially data dependent because global investors seem to be firmly ensconced in “show-me” mode. It has been our sense as a firm, supported by the impression we got from last week’s meetings, that investors are reluctant to give growth prospects, and risk assets, the benefit of the doubt. Ground down by trade-related tweets, and skeptical that the latest wave of extraordinary monetary policy measures will have a perceptible impact on growth or inflation, they want to see definitive evidence of a turn before they’ll adjust their portfolio positioning to accommodate it. The wariness is also a reflection of the conflicting signals issued late in the business cycle and the elevated levels of geopolitical uncertainty. If the global economy turns as we think it soon will, global investors should be prepared to add cyclical exposures to their portfolios, even if Elizabeth Warren solidifies her current status as the front-runner for the Democratic nomination. That sense of wariness keeps us recommending benchmark duration exposure in fixed income portfolios over the 0-to-3-month tactical timeframe, though we have little appetite for interest-rate exposure looking out beyond the near term, and are below-benchmark duration over the 3-to-12-month cyclical and greater-than-12-month strategic timeframes. We still like spread product over the full 12-month horizon, as we expect stronger growth will make viable U.S. corporations better credits and that ZIRP/NIRP will continue to protect some of the rest. We endorse the house view that relative U.S. equity returns may slow, but global growth should give a boost to absolute equity returns, and we continue to recommend that investors remain at least equal weight equities in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 We are in accord with Chair Powell’s stated view that the rate cuts are mid-cycle cuts, not the beginning of a new easing cycle.

Highlights The currency market is bifurcated in terms of shorter-term expectations versus longer-term factors. The Swedish krona, Norwegian krone, and British pound are solid long-term buys, but could remain very volatile in the short term. We continue to focus on the crosses rather than outright dollar bets. Remain long SEK/NZD, GBP/JPY, and NOK/SEK. Tighten stops on long GBP/JPY to protect profits. EUR/SEK should top out once global growth improves. Sell the gold/silver ratio at 90, as recommended in last week’s report.1 Feature Chart I-1One Way Street Since 2018 Of all the G10 currencies we follow, the Swedish krona is probably the one that is the most perplexing. The Riksbank is one of the few central banks to have raised rates this year, but the krona remains the weakest G10 currency. Admittedly, the performance of the Swedish manufacturing sector has been dismal, and was especially so in September, but this has not been a story specific to Sweden alone. The euro area, which is also experiencing a deep manufacturing recession, has seen better currency performance despite a more dovish European Central Bank (ECB). The underperformance of the krona begs the question of whether it signals a much prolonged global manufacturing recession, or is indicative of something more endogenous to Sweden. Put another way, has the driver of USD/SEK (and even USD/NOK) strength been an appreciating dollar, or more domestic factors (Chart I-1)? And if it is the latter, what are the important signposts to look out for should a turnaround be around the corner? The Soft Versus Hard Data Debate The big question for Sweden is whether the manufacturing sector is just in a volatile bottoming process, or about to contract much further. Industrial production is currently growing at 4% year-over-year, but the signal from the soft data is that it should be contracting in the double digits (Chart I-2, top panel). As such there is either a big disconnect between the perception of investors and reality, or we are on the verge of a much deeper manufacturing slump. Exchange rates tend to be extremely fluid in discounting a wide swath of economic data, and in the case of Sweden, in discounting the outcome for global growth. However, with EUR/SEK at 10.8 and USD/SEK at 9.7 – the latter well above its 2008 highs – it is fair to assume that anything other than a deep recession will justify a stronger SEK.  One of the more consistent ratios in calling a bottom in the Swedish manufacturing sector in particular (and that of the Eurozone in general) is the manufacturing new orders-to-inventories ratio (Chart I-2, bottom panel). The tick down in September was disconcerting. However, unlike the manufacturing PMI, this ratio is not hitting new lows, tentative evidence that we might be in a volatile bottoming process rather than a protracted slump. The last time we encountered such a divergence was in 2011/2012, at the height of the European debt crisis; in that instance, Swedish hard data ended up sending the right signal for the overall economy. The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular.  The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular. The import component of the PMI index remains well above that of exports. Meanwhile, the employment component of the PMI index began to stabilize around the middle of this year, meaning employment growth should bottom at around 1% or so (Chart I-3). Swedish exports are higher up the manufacturing food chain than in most other developed economies, and autos are quite important. But so far, the Swedish economy has weathered the auto slowdown quite well, with production still clocking in at 7% per year. Chart I-2Soft Data Is Much Worse Chart I-3Domestic Demand Is Holding Up Well The tick up in the Swedish unemployment rate is problematic, but we do not believe it constitutes a major change in labor market dynamics. Sweden has a long history of higher openness toward asylum seekers and refugees than many other European countries. The Syrian crisis a couple of years ago led to an exceptional surge, where the number of asylum seekers skyrocketed to over 150,000 or almost 1.5% of the total population (Chart I-4). Historically, immigration has provided a big labor dividend to Sweden, allowing growth to outpace both the U.S. and the euro area. But this has also been a source of frictional unemployment, as new migrants integrate into the labor force. Chart I-4A New Pool Of Labor That Has To Be Integrated Foreign-born workers now constitute about 20% of the total population, a big portion of which need to learn a new language and adopt new skills (Chart I-5A). This growth dividend will be reaped for many years to come. Integration is a politically contentious issue, and so the highly restrictive asylum and reunification law adopted in mid-2016 probably means the immigration boom is behind us. The rise of the anti-immigration Sweden Democrats in the September 2018 elections is a case in point. However, the pivot of the democratic population towards the right has been a global phenomenon, and so is not as negative for Sweden on a relative basis. All that to say, compared to most developed nations, Sweden still enjoys a relatively positive demographic outlook (Chart I-5B). Chart I-5AA Huge Labor Dividend Chart I-5BNo Apparent Demographic Cliff The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase in the share of employment that pays lower wages, there is still upward pressure on housing and consumption in response to the increased number of workers. This comes on top of a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 15%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. But as the new labor force is finally absorbed into the economy, it should start to generate meaningful wage pressures. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. Interest rates were cut to negative territory in 2015 and held at -0.5% (lower than the ECB policy rate) all through the global recovery in 2016 and 2017. Quantitative easing has also been extended up until 2020, well ahead of the ECB’s renewed asset purchase program announcement. Both have tremendously eased monetary conditions in Sweden, including via a weaker currency. Going forward, there are a few key reasons to believe  the path of least resistance for the krona is now up: A weak krona has typically helped the manufacturing sector with a lag of twelve months.  A weak krona has typically helped the manufacturing sector with a lag of twelve months. Negative divergences only tend to happen ahead of deep recessions. Unless we are in that particular situation now, better demand for relatively cheaper Swedish goods (think Volvo versus BMW) should lead to a stronger krona (Chart I-6). Yes, the Riskbank has been conducting QE, but the pace of expansion in its balance sheet has been slowing in recent quarters. USD/SEK has tended to track relative balance sheet trends between the Riksbank and the Fed, but a gaping wedge has opened up in favor of the krona (Chart I-7). Meanwhile, with the Fed about to re-expand its balance sheet, this should also favor a stronger SEK versus the USD. Chart I-6Swedish Krona And Manufacturing Chart I-7USD/SEK And Relative Balance Sheets The Swedish housing market is becoming a thorn in the Riksbank’s side. When negative rates were introduced in 2015, growth in house prices exploded to the tune of 15% year-on-year (Chart I-8). More recently, a curb on migration has allowed a cooling of sorts, but Swedish household leverage remains very elevated. With the memory of the 1990s housing crisis still fresh in their minds, this is making the Riksbank quite uncomfortable with its current policy stance. The carry cost is lower from being short NZD compared to being short the U.S. dollar. Our bias is that though Governor Stefan Ingves prefers to renormalize policy as quickly as possible, given that he is managing a small-open economy with trade a whopping 45% of GDP, but is held hostage to external conditions. The SEK is the cheapest currency in the G10 universe, and could bounce sharply on even the softest evidence indicating global growth has bottomed. Furthermore, rising global growth will tighten resource utilization, which should begin to boost underlying inflationary pressures in Sweden (Chart I-9) Chart I-8House Prices In Sweden##br## Are Bubbly Chart I-9Resource Utilization And Inflation In Sweden In terms of SEK trading strategy, USD/SEK and NZD/SEK tend to be highly correlated; since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% for New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD/SEK downside. Meanwhile, the carry cost is lower from being short NZD compared to being short the U.S. dollar (Chart I-10). As for EUR/SEK, the cross could consolidate at current levels before heading lower but will ultimately peak once global growth reaccelerates. Chart I-10Remain Long SEK/NZD Bottom Line: We remain long the SEK/NZD as a relative value play, but the true upside lies in the SEK/USD cross. Our bias is that SEK weakness has been driven by the market’s focus on disappointing soft data, while hard data remains relatively resilient. Once it becomes clearer that the global growth environment is not as precarious as the surveys suggest, the krona could bounce sharply. Housekeeping Our long GBP/JPY position hit 5% this week. We are tightening stops to 138 in order to protect profits. We were also stopped out of short EUR/NOK for a 2% loss. We are standing aside for now. EUR/NOK is now trading above 2008 recession levels, which is only justifiable by a prolonged growth recession, but risk management warrants patience for now. Stay tuned.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: Retail sales contracted by 0.3% month-on-month in September. Industrial production fell by 0.4% month-on-month. Both export and import prices fell by 1.6% year-on-year in September. Michigan Consumer Sentiment Index grew to 96 in October, up from 93.2 in the previous month. NY Empire State Manufacturing Index increased to 4 in October, up from 2 in September. Building permits and housing starts both fell by 2.7% and 9.4% month-on-month in September, but the housing recovery remains intact. Initial jobless claims increased to 214K for the week ended Oct 11th. The DXY index depreciated by 0.7% this week. The latest Beige Book summarized that the U.S. economy expanded at a slight-to-modest pace. The slowdown in the manufacturing sector remains the biggest risk to the economy, while trade tensions continue to weigh on business sentiment and capex intensions. The most recent “entente” in trade discussions might represent a pivotal shift from heightened uncertainty that has prevailed throughout the summer. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area remain subdued: Headline inflation fell to 0.8% year-on-year in September, the slowest in nearly three years. Core inflation however, increased to 1% year-on-year. Industrial production in the euro area continued to contract, by 2.8% year-on-year in August. The ZEW sentiment in the euro area fell further to -23.5 in October, however this is well above expectations of -33. The ZEW sentiment for Germany also fell to -22.8 in October. It is worth noting that expectations continue to improve relative to the current situation. The trade balance in the euro area improved to €20.3 billion in August, up from the downward-revised €17.5 billion in July. However, this is mostly due to a contraction in imports. EUR/USD rose by 0.9% this week, in part helped by broad dollar weakness. The trade dynamics in the euro area remain worrisome: exports fell by 2.2% year-on-year in August, while imports plunged by 4.1% year-on-year. Notably, year-to-date, the EU’s trade surplus with U.S. grew to €103 billion, up from €91 billion a year earlier, while the trade deficit with China widened further to €127 billion from €116 billion. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan continue to disappoint: Industrial production fell by 4.7% year-on-year in August. Capacity utilization decreased by 2.9% month-on-month in August. The Japanese yen fell by 0.8% against the U.S. dollar this week. Kuroda has again emphasized that the BoJ will not hesitate to act if economic developments continue to deteriorate. On the other hand, while the Fed and the ECB are both on course to expand their balance sheets through asset purchases, it is an open question as to how much more the BoJ can do, beyond yield curve control. We remain long the yen in anticipation that it will require a “Lehman moment” for the BoJ to act aggressively. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly negative: The ILO unemployment rate slightly increased to 3.9% in August. Average earnings quarterly growth slowed to 3.8%, however this was above expectations of 3.7%. The Retail price index grew by 2.4% year-on-year in September, a slowdown from 2.6% in the previous month. Headline inflation was unchanged at 1.7% year-on-year in September, while core inflation jumped to 1.7% from 1.5%. Retail sales grew by 3.1% year-on-year in September, up from 2.6% in the previous month. GBP/USD surged by 3.3% this week on optimism towards the European Council Summit on Brexit. From a valuation perspective, the pound is trading at a large discount to its fair value. Should positive Brexit news continue to hit the headlines, the pound could continue to soar. We are long GBP/JPY, which is above 5% in the money. Tighten stop to 138. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been modest: NAB business confidence fell further to -2, while conditions improved to 1 in Q3. On the labor market front, the unemployment rate fell further to 5.2% in September. 14.7K jobs were created, consisting of 26.2K full-time jobs and a loss of 11.4K part-time jobs. AUD/USD increased by 0.4% this week. RBA minutes were released earlier this week. Interestingly, it presents a sharp debate about the effects of low rates. On the one hand, lower rates have been theoretically justified to achieve full employment and the inflation target. On the other hand, some RBA members fear that low rates could fuel already inflated house prices. The probability for another rate cut has thus decreased post RBA minutes. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals increased by 1.8% year-on-year in August, slightly down from 2% in the previous month. Headline inflation slowed to 1.5% year-on-year in Q3. NZD/USD has been more or less flat this week. Closely tied to global growth, the New Zealand dollar has been fluctuating with the ebb and flow of the U.S.-China trade headlines. The two countries have agreed on a partial deal last week, however the details remain vague. While the kiwi is a high beta currency, it should unerperform at the crosses. We continue to play the kiwi weakness through the Aussie dollar and the Swedish Krona. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been relatively strong: The unemployment rate decreased further to 5.5% in September. Moreover, average hourly wages continued to grow by 4.3% year-on-year, up from 3.8% in the previous month. Lastly, 53.7K jobs were created in September, well above expectations of 10K. Both headline and core inflation were unchanged at 1.9% year-on-year in September. The Canadian dollar has appreciated by 1% against the U.S. dollar, on the back of the positive employment data last Friday. All eyes are on the federal election this month, which could be crucial for the future of the Canadian energy sector and environment policies.  Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus (excluding precious metals) widened sharply to CHF 2.88 billion in September. Notably, Swiss exports grew by 8.2% month-on-month to CHF 20.3 billion, led by higher sales of chemical and pharmaceutical products. Swiss imports slightly dropped by 1.4% month-on-month to CHF 17.4 billion. Producer and import prices continued to fall by 2% year-on-year in September. USD/CHF fell by 1% this week. The Swiss franc will continue to fight a tug-of-war between being a defensive currency, but a tool of manipulation by the SNB. Our guestimate is that EUR/CHF 1.06 is an ultimate stress point.  Global portfolios should hold the Swiss franc as insurance, for the simple reason that the currency is a structural outperformer. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been depressed: The trade balance shifted to a deficit of NOK 1.2 billion in September. That’s a decrease of NOK 24 billion year-on-year. The Norwegian krone has depreciated by nearly 1% against the U.S. dollar this week. Energy prices remain subdued over the past few weeks. Moreover, the Norwegian trade balance has shifted to a deficit for the first time since November 2017. Exports plunged by 19.5% year-on-year, due to lower sales of energy products, while imports jumped by 12.9% year-on-year. The message is clear – Norway continues to hold up well domestically, but dependence on petroleum exports is introducing volatility into any growth forecasts. BCA has lowered its oil price projections for 2019, which has dampened the appeal of the Norwegian Krone. Stay tuned. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been neutral: The unemployment rate was unchanged at 7.1% in September. USD/SEK fell by 1.1% this week. As the worst performing G-10 currency this year, the Swedish krona is now trading at a large discount to its fair value. Please refer to our front section this week which presents an in-depth analysis on the Swedish economy and the krona. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 201 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Special Report

Today we are also publishing a Special Report titled Chinese Auto Demand: Time For A Recovery? Highlights India is the third-largest world consumer of crude oil. Hence, fluctuations in its oil consumption is a non-negligible factor behind global oil prices. India’s petroleum demand growth is slowing cyclically due to the domestic demand slump and a dramatic drop in vehicle sales. This, combined with China’s ongoing slowdown in petroleum product demand, will have a non-trivial impact on oil prices in the next six months. From a structural perspective, India’s long-term demand growth for petroleum is decelerating as well. Feature India’s petroleum products consumption growth is slowing. Chart 1India Is The World's Third Largest Crude Oil Consumer India is the world’s third-largest consumer of crude oil, guzzling 5% of global consumption (Chart 1). Hence, fluctuations in India’s crude oil/petroleum consumption is a non-negligible factor affecting global oil prices. India’s petroleum products consumption growth is slowing. This comes on top of China’s ongoing petroleum demand deceleration. Together, the two countries account for 19% of the world’s oil intake. Therefore, deceleration in their oil consumption growth will have a considerable impact on the outlook for global oil demand growth. A Pronounced Cyclical Oil Demand Slump Indian petroleum consumption growth has decelerated significantly on the back of slumps in Indian domestic spending and economic activity (Chart 2). Please click on this link for an in-depth analysis on the domestic demand slump in India. Chart 2Indian Petroleum Consumption Growth Has Been Dwindling Specifically, vehicle purchases and industrial sectors have been hit hard. These sectors are critical for Indian petroleum consumption, since transportation demand accounts for 50% and industrial activity for around 25% of total petroleum consumption (Chart 3). Indian vehicle sales have been in freefall. Chart 3Transportation & Industry Guzzle The Most Fuel In India Chart 4Indian Vehicle Sales Are In Deep Contraction Indian vehicle sales have been in freefall. Chart 4 shows passenger car sales are shrinking at 30% and sales of two and three-wheeler units are contracting at 20% from a year ago. Moreover, commercial vehicles and tractor unit sales are falling at annual rates of 35% and 10%, respectively. Chart 5 illustrates that the number of registered vehicles is expanding at a lower rate than before – i.e., its second derivative has turned negative. This signals a further growth slowdown in gasoline and diesel consumption. We use the second derivative in this analysis because registered vehicles are a stock variable. However, we are trying to explain changes in petroleum consumption which is a flow variable. Therefore, the second derivative of a stock variable (the number of registered cars on the road) explains the first derivative of a flow variable (the growth rate of oil consumption). Looking ahead, vehicle sales will remain in the doldrums because of a lack of financing. In particular, the impulse on auto loans issued by commercial banks is negative (Chart 6). Chart 5Slowing Growth Of Vehicles On The Road = Weaker Pace Of Fuel Consumption Chart 6Indian Banks: Negative Vehicle Loan Impulse More worrisome is the ongoing turmoil in India’s non-bank finance sector (NBFCs), which has also significantly hit auto sales. In the past, the NBFC sector played a major role in funding Indian auto purchases. For instance, according to the ICRA, an independent rating agency in India, NBFCs have helped fund the purchases of 65% of two-wheelers, 30% of passenger cars and around 55% of commercial vehicles – both new and used. Given these non-bank finance companies are currently facing formidable funding and liquidity pressures amid rising NPLs (Chart 7), they are being forced to shrink their balance sheets. This is damaging to auto sales. Please click here for an in-depth analysis on the Indian banking and non-bank finance sectors. Chart 7Major Asset-Liability Mismatches Among Indian Non-Bank Finance Sector Chart 8India's Capex Has Been Weak Turning to the industrial sector, overall Indian capital spending has been weak. India’s real gross fixed capital formation has rolled over, the number of capex projects underway is nosediving and both capital goods imports and production are contracting by 7% and 12% on an annual basis (Chart 8). Falling industrial activity has taken a toll on the consumption growth of petroleum products with industrial applications, such as bitumen, naphtha and petroleum coke, etc. The growth rate in demand for these products is dropping — a significant development since they account for 25% of overall petroleum consumption in India.1  Bottom Line: India’s petroleum consumption growth has been slowing drastically from a cyclical perspective. And Moderating Structural Oil Demand Growth It appears there are structural factors at play that will also reduce India’s long-term demand for petroleum. On top of the cyclical demand slowdown, it appears there are structural factors at play that will also reduce India’s long-term demand for petroleum: Chart 9Impressive Efficiency Gains In India's Vehicle Fleet The fuel efficiency of India’s vehicle fleet is markedly improving (Chart 9). Additionally, since 2015-16 the Indian government has been proactively pursuing new emission/fuel efficiency standards. For instance, emissions standards for new passenger vehicles will fall to 4.2 L/100 KM by 2023 down from its current level of 4.6 L/100 KM. This will lead to a 7% reduction in auto fuel consumption. While this is not a large reduction, the government has the scope to implement even stricter standards since Indian car makers are easily meeting these targets. Finally, the Indian government has been aggressively promoting electric vehicles (EVs) as an alternative to traditional autos. It has made the advancement of this sector a priority. Ownership of EVs is currently negligible in India. However, the government is pushing for EVs to make up 30% of vehicle sales by 2030. In addition, it has been providing incentives such as sales tax cuts and subsidies to the sector. Finally, Mahindra and Tata Motors are already establishing a lead in the EV industry and are developing new EV models in collaboration with foreign automakers.  Bottom Line: The pace of India’s structural demand for petroleum will also be downshifting. Oil Inventory Not A Critical Factor Chart 10China: Oil Inventory Drives Oil Imports Inventory accumulation and destocking can play an important role in oil price fluctuations. For example, inventory accumulation plays a key role in driving Chinese crude oil imports (Chart 10). There is a dearth of data on Indian oil inventories to make a strong inference about its de- and re-stocking cycles. However, we have the following observations: India has the capacity to store 5.33 million tons worth of strategic oil reserves - equivalent to around 10 days of its crude oil consumption. It is not clear whether or not these reserves are at full capacity. However, even if we assume they are only 50% full and the government decides to fill its reserves all at once, this would require the importation of an additional 2.67 million tons of oil, equivalent to only 1.2% of Indian crude oil imports and 0.05% of global crude oil demand. This is a negligible amount, and is unlikely to have any impact on global oil prices. Furthermore, while the Indian government is planning to expand its storage capacity by an extra 6.5 million tons, this will only take place in the next six to eight years. Thus, it will not meaningfully affect oil imports in the medium term. Chart 11India: Oil Consumption Drives Oil Imports Finally, India’s crude oil imports are strongly correlated with its petroleum final consumption (Chart 11). Therefore, it is reasonable to assume that Indian consumption – not the oil inventory cycle – is relevant for crude imports, and by extension for oil prices. Bottom Line: India’s petroleum product and crude oil inventory fluctuations are too small to influence the nation’s crude imports and hence global oil prices. Investment Conclusions From a cyclical perspective, Indian final demand for crude oil has been weakening. A major re-acceleration in economic growth and hence oil demand is not imminent. We discuss the outlook for China’s auto sales in a separate report published today. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. Chart 12Expansion Pace Of Vehicles On The Road Has Downshifted In India & China Our estimations for annual growth in cars on the road (excluding 2-wheelers) has dropped to 5.8% in India and 10.5% in China (Chart 12). This entails a slower pace of oil demand growth than in the past. Besides, if one rightly assumes petroleum consumption per car is declining for structural reasons due to technological advancements by car manufacturers and enforcement of stricter efficiency standards by governments, oil consumption growth will be considerably slower going forward relative to the past 20 years. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. This presents a major risk for crude prices in the next 6 months or so. Beyond the cyclical horizon, the long-term demand outlook for oil is also downbeat. Please note that this is the view of BCA’s Emerging Markets Strategy team, and differs from that of BCA’s house view, which is bullish on oil. Chart 13India’s Relative Equities Performance Benefits From Lower Oil Prices In turn, low oil prices are positive for the relative performance of Indian stocks versus the EM equity benchmark (Chart 13). This was among the primary reasons why we upgraded the allocation to this bourse within an EM equity portfolio to neutral from underweight on September 26, 2019. In absolute terms, the outlook for Indian share prices remains downbeat, as discussed in the same report. Finally, to express our negative view on oil prices, we are reiterating our short oil and copper / long gold position recommended on July 11, 2019. Industrial commodities such as copper and oil will continue to underperform gold prices in the medium term (the next six months). Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com   Footnotes 1      Diesel consumption will also be impacted. While the latter is mostly consumed by the transportation sector in India, diesel does have some industrial applications as well. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese automobile industry outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima China Strategist Feature Chart 1Chinese Economy Likely To Bottom In Q1 President Trump announced last Friday the first phase of a potential trade agreement with China. For now, the most concrete aspect of the announcement has been the deferral of an increase in tariffs that had been scheduled to occur this week, in exchange for agriculture purchase commitments from China. Market participants initially reacted with caution to the news, given the U.S. administration’s about-face in early-May and given signs from Beijing that China “needs time” to finalize a deal. However, Chinese policymakers have subsequently played up the progress made during the negotiations, and characterized both sides as being on “the same page”. We noted in last week’s report that China’s economy was likely to stabilize in Q1 of next year (Chart 1), but that a further shock to China’s external sector and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown.1 This, to us, justified a tactically bearish stance towards Chinese stocks, despite our positive cyclical bias. Indeed, following our tactical underweight call initiated on July 24,2 relative to global stocks, Chinese investable stocks dropped nearly 3% in the months of August and September in reaction to intensified trade tension. Chart 2Chinese Stocks Have Been Underperforming Since Late April While it is not yet clear how substantive the final deal between the U.S. and China will be, it is our judgment that the odds of a further escalation in the trade war have legitimately fallen over the past week. Both sides of the negotiating table have strong incentives to reach a deal (particularly the U.S.), and both U.S. and Chinese policymakers may finally be acting in a way that is consistent with each side’s respective constraints. As such, we no longer feel that a tactical underweight stance is warranted, and we recommend that clients maintain a neutral stance towards Chinese stocks over the near term. The potential for the talks to collapse once again is keeping us from recommending an outright overweight tactical stance, as well as the small but still non-trivial chance that the final deal is not meaningful enough to help revive economic activity. Cyclically, a substantive trade deal would be bullish for Chinese stocks, as the relative performance of both the investable and domestic markets are meaningfully below their late-April highs (Chart 2). The stimulus that policymakers have already provided should be enough to stabilize Chinese domestic demand, and a trade deal should help reinforce a stabilization in sentiment and activity over the coming year. However, one risk to our cyclical positioning is that the removal of uncertainty for China’s exporters strengthens the will of Chinese policymakers to curb “excess” credit growth. For now, this remains “a story for another day”, as investors will almost certainly bid up Chinese stocks (particularly the investable market) in reaction to a deal. But the behavior of China’s credit impulse following the surge in Q1 of this year underscores that policymakers are very serious about preventing another significant rise in the macro leverage ratio. This could lead to a less optimistic outlook over the coming 6-12 months than we originally expected when we recommended upgrading Chinese stocks earlier this year, and is a risk that we will be continually monitoring over the coming months. Stay tuned!   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1      Please see China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing”, dated October 9, 2019, available at cis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations