Economy

Highlights So What? Prime Minister Boris Johnson’s threat to take the U.K. out of the EU without a withdrawal deal in place is a substantial 21% risk. Why? The odds of a no-deal exit could range from today’s 21% to around 30%, depending on whether Johnson manages to obtain some concessions from the EU in forthcoming negotiations. It is far too early to go bottom-feeding for the pound sterling, as Brexit risks are asymmetrical. We maintain our tactically cautious positioning, despite some cyclical improvements, due to elevated geopolitical risks in the United States, East Asia, and the Middle East. Feature Thank you Mr. Speaker, and of course I should welcome the prime minister to his place … the last prime minister of the United Kingdom. – Ian Blackford, head of the Scottish National Party in Westminster, July 25, 2019 Chart 1No-Deal Brexit Would Come At A Very Bad Time The Federal Reserve cut interest rates for the first time since the global financial crisis in 2008 on July 31. The Fed suggested that the door is open for future cuts, though Chairman Jerome Powell signaled that the cut should not be seen as the launch of a “lengthy rate cutting cycle” but rather as a “mid-cycle adjustment” comparable to cuts in 1995 and 1998. President Donald Trump responded by declaring a new 10% tariff on $300 billion worth of imports from China! He resumed criticizing Powell for insufficient dovishness – and Trump could in fact fire Powell, though the decision would be contested at the Supreme Court. The Fed’s move shows that Trump’s direct handle on interest rates comes from his ability to control trade policy and hence affect the “the external sector.” The trade war with China has exacerbated a global manufacturing slowdown that is keeping global growth and U.S. inflation weak enough to justify additional rate cuts with each future deterioration (Chart 1). Improvements in global monetary and fiscal policy suggest that the U.S. and global economic expansion will be extended to 2021 or beyond, which is positive for equities relative to government bonds or cash, but we remain defensively positioned in the near-term due to a range of geopolitical risks, highlighted by the new tariffs. The unconvincing U.S.-China tariff ceasefire agreed at the Osaka G20 has fallen apart as we expected; the period of “fire and fury” between the U.S. and Iran continues; and the U.S. is entering what we expect to be a period of socio-political instability in the lead up to the momentous 2020 presidential election. Moreover the risk of a “no deal” Brexit, in which the U.K. exits the European Union and reverts to basic World Trade Organization tariff levels, is rising and will create acute uncertainty over the next three months despite the world’s easy monetary policy settings (Charts 2A & 2B). In June we upgraded our odds of a no-deal Brexit to 21%, up from 7% this spring. While not our base case, the probability is too high for comfort and the critical timing for the rest of Europe warns against taking on additional risk. The risk of a “no deal” Brexit ... is rising and will create acute uncertainty. Chart 2AUncertainty And Sentiment Getting Worse ... Chart 2B... Despite Easy Monetary Policy BoJo’s Gambit Boris Johnson – aka “BoJo” – former mayor of London and foreign secretary, cemented his position as the U.K.’s 77th prime minister on July 24. He immediately launched a gambit to renegotiate the U.K.’s withdrawal. He is threatening not to pay the “divorce bill” (the U.K.’s outstanding budget contributions for the 2014-20 budget period and other liabilities in subsequent decades) of 39 billion pounds. He insists that the Irish backstop (which would keep Northern Ireland or the U.K. in the EU customs union to prevent a hard border between the two Irelands) must be abandoned. He has stacked his cabinet with pro-Brexit hardliners who share his “do or die” stance that Brexit must occur on October 31 regardless of whether an agreement for an orderly exit is in place. These developments were anticipated – hence the decline in our GeoRisk indicator – but the pound sterling is falling now that the confrontation is truly getting under way (Chart 3). Parliament is adjourned in August, so Johnson’s hardline negotiating tactics will get full play in the media cycle until early September, when the real showdown begins. Crunch time will likely run up to the eleventh hour, with Halloween marking an ominous deadline. There is plenty of room for the pound to fall further throughout this period, according to our European Investment Strategy’s handy measure (Chart 4), because the success of Boris’s gambit depends entirely upon creating a credible threat of crashing out of the EU in order to wring concessions that could conceivably pass through the British parliament. Chart 3Our Market-Based Indicator Suggests Still Some Complacency On Brexit Risks Chart 4GBP-EUR Still Has Room To Fall Under BoJo's Gambit Geopolitically, the United Kingdom is not prohibited from exiting the EU without a deal. Though the empire is a thing of the past, the U.K. remains a major world power. It has Europe’s second-largest economy, nuclear weapons, a blue-water navy, a leading voice in global political institutions, and is a close ally of the United States. It mints its own coin. It is a sovereign entity that can survive on its own just as Japan can survive on its own. This geopolitical foundation always supported our view that there was a 50% chance of the referendum passing in 2016, and today it supports the view that fears over a no-deal Brexit are not misplaced. Investors should therefore not confuse Johnson’s bluster with that of Alexis Tsipras in 2015. A British government dead-set on delivering this outcome – given the popular mandate from the 2016 referendum and the government’s constitutional handling of foreign affairs as opposed to parliament – can probably achieve it. However, the probability of a no-deal Brexit may become overstated in the next two-to-three months. Economically and politically, a no-deal exit is extremely difficult to follow through on – hence our 21% probability. Estimates of the negative economic impact range from a 2% reduction in GDP growth to an 11% reduction (Table 1). The 8% drop cited by Scottish National Party leader Ian Blackford in his denunciation of Prime Minister Johnson’s strategy is probably exaggerated. The U.K.’s recorded twentieth-century recessions range from 2%-7% (Chart 5). These offer as good of a benchmark as any. While a no-deal exit is probably not going to create a shock the same size as the Great Depression or the Great Recession, the recessions of 1979 and 1990 would be bad enough for any prime minister or ruling party. Table 1Wide Range Of Estimates For Impact Of No-Deal Brexit A small recession could also spiral out of control – it could create a vicious spiral with the European continent, which is already on the verge of recession. And it could damage consumer confidence more than anticipated – as it would be accompanied by immediate social and political unrest due to the half of the population that opposes Brexit in all forms. Politicians have to pay attention to the opinion polls as well as the referendum result, since opinion polls impact the next election. These show a plurality in favor of remaining in the EU and a strong trend against Brexit since 2017 – a factor that the currency markets are ignoring at the moment (Chart 6). While the evidence does not prove that a second referendum would result in Bremain, it is highly likely that a majority opposes a no-deal exit, given that at least a handful of pro-Brexit voters do not want to leave without a deal. The results of the European parliamentary elections in May (Chart 7) and the public’s preferences for different political parties (Chart 8) both support this conclusion. Chart 6Plurality Of Voters Still Favors Bremain Over Brexit Chart 8Voters Favor Bremain-Leaning Political Parties Parliament is also opposed to a no-deal Brexit. Though the Cooper-Letwin bill that forbad a no-deal exit initially passed by one vote in April (Chart 9A), the final amended version passed with a majority of 309 votes. Further, in July, with the rise of Boris Johnson, parliament passed a measure by 41 votes that requires parliament to sit this fall (Chart 9B), thus attempting to prevent Boris from proroguing parliament and forcing a no-deal Brexit that way. Technically Queen Elizabeth II could still prorogue parliament, but we highly doubt she would intervene in a way that would divide the nation. Johnson himself will have to face the reality of parliament and public opinion. Parliament has one crystal clear means of halting a no-deal exit: a vote of no confidence in Johnson’s government.1 Theresa May only survived her vote of no confidence by 19 seats. Yet Johnson is entering 10 Downing Street at a time when parliament is essentially hung. The Conservative Party’s coalition with Northern Ireland’s Democratic Union Party has been reduced to a majority of two, which is likely to fall to a single solitary seat after the Brecon and Radnorshire by-election, which is taking place as we go to press. Johnson has purged several Tories from his cabinet, and there are a handful of Conservatives who are firmly opposed to a no-deal Brexit. It would be an extremely tight vote as to whether these Tory rebels would be willing and able to bring down one of their own governments – a careful assessment suggests that there are about half a dozen swing voters on each side of the House of Commons.2 But 47 Conservatives contrived to block prorogation (see Chart 9B). The magnitude of the crisis members of parliament would face – an unpopular, self-inflicted no-deal exit and recession – is essential context that would motivate rebellious voting behavior. Parliament’s actions so far, the reality of the economic impact, and the popular polling suggest that MPs are likely to halt the Johnson government from forcing a no-deal exit if he makes a mad dash for it. More likely is that Johnson himself pushes to hold an election after securing some technical concessions from Brussels. He is galvanizing the Conservative vote and swallowing up the single-issue Brexit vote (UKIP and the Brexit Party), while the opposition remains divided between the Labour Party under the vacillating Jeremy Corbyn and the resurgent Liberal Democrats (Chart 10). In a first-past-the-post electoral system, this provides a window of opportunity for the Conservatives to improve their parliamentary majority – assuming that Johnson has renegotiated a deal with the EU and has something to show for it. Chart 10BoJo Could Call Election With Deal In Hand Chart 11Ireland Can Compromise For Stability's Sake This would require the EU to delay the deadline yet again (September 3 is the last date for a non-confidence vote to force a pre-Brexit October 24 election). The European Union has a self-interest in preventing a no-deal Brexit, as it needs to maintain economic stability. It ultimately would prefer to keep the U.K. in the bloc, which means that delays can ultimately be granted, especially to accommodate a new election. As to what kind of compromises are available, the Irish backstop can suffer technical changes to its provisions, time frames, or application. In the end, the Irish Sea is already a different kind of border than the other borders in the U.K. and therefore it is possible to enact additional checks that nevertheless have a claim to retaining the integrity of the United Kingdom. The Democratic Unionists could find themselves outnumbered on this issue. Certainly the Republic of Ireland has an interest in preventing a no-deal Brexit as long as a hard border with Northern Ireland is avoided, and Boris Johnson maintains that it will be (Chart 11). The risk of a no-deal Brexit is around 21% Our updated Brexit Decision Tree in Diagram 1 provides the outcomes. Former Prime Minister Theresa May failed three times to pass her Brexit deal. We allot a 30% chance, higher than consensus, that Boris Johnson can do it through galvanizing the Conservative vote – given that he is operating with a hung parliament and is at odds with the median voter on Brexit. We give 21% odds to a no-deal Brexit based on the difficulty of parliament outright halting Johnson if his government is absolutely determined to follow through with it. This is clearly a large risk but not our base case. We would upgrade these odds to around 30% in the event that negotiations with the EU completely fail to produce tangible outcomes. It is far more likely that a delay occurs and leads to new elections (49%) – and these odds rise to 70% if Johnson fails to extract concessions from the EU that enable him to pass a deal through parliament. Diagram 1Brexit Decision Tree (Updated As Of June 21 For Boris Johnson) A final constraint on Johnson comes from Scotland, as highlighted in the epigraph at the top of the report: the demand for a new Scottish independence referendum is reviving as a result of opposition to Brexit in general and specifically to Prime Minister Johnson’s hardline approach (Charts 12A & 12B). The SNP is also improving its favorability among Scottish voters relative to other parties (Chart 13). We have highlighted this risk in the past: support for Scottish independence does not have a clear ceiling amid the antagonism over Brexit, especially if an economic and political shock hits the union as a result of a forced no-deal exit. Chart 13Scottish Nationals Resurgent Bottom Line: The risk of a no-deal Brexit is around 21%, though a complete failure of negotiations with the EU could push it up to 30%. If it occurs it will induce a recession and eventually could result in the breakup of the union with Scotland. China And Investment Recommendations What can investors be certain of regardless of the different Brexit outcomes? The United Kingdom will reverse the fiscal austerity of recent years (Chart 14). Fiscal stimulus will be necessary either to offset the shock of a no-deal exit in the worst-case scenario, or to address the ongoing economic challenges and public grievances in a soft Brexit or no Brexit scenario. These grievances stem from the negative impact on the middle class of globalization, post-financial crisis deleveraging, low real wage growth, and the decline in productivity. Potential GDP growth is set to fall if immigration is curtailed and restrictions on trade with the EU go up. The government will have to offset this trend with spending to boost the social safety net and encourage investment. Chart 14Fiscal Austerity To Go Into Reverse The pound is clearly weak on a long-term and structural basis (Chart 15). Based on our assessment of the British median voter – opposed to a no-deal Brexit – and the fact that parliament is also opposed to a no-deal Brexit Chart 15Deep Value In Sterling and is the supreme lawgiving body in the British constitution, we expect that an enormous buying opportunity will emerge when Prime Minister Johnson’s gambit has reached its apex and he is either forced to accept what concessions the EU will give. But if forced out of office, election uncertainty due to a potential Prime Minister Jeremy Corbyn will prolong the pound’s weakness. Brexit is not the only risk affecting Europe this summer – a critical factor is Europe’s own economic status, which in great part hinges on our China view (Chart 16). The Chinese Communist Party’s mid-year Politburo meeting struck a more accommodative tone relative to the April meeting that sounded less dovish in the aftermath of the Q1 credit splurge. The emphasis of the remarks shifted back to the need to take additional measures to stabilize the economy, as in the October 2018 statement. This fits with our view since February that Chinese stimulus will surprise to the upside this year. Chart 16Chinese Reflation Positive For Europe Policymakers’ efforts are working thus far, with signs of stabilization occurring in the all-important labor market (Chart 17). There is some evidence that Xi Jinping’s anti-corruption campaign is moderating, which also supports the view that policy settings in the broadest sense are becoming more supportive of growth (Chart 18). Chart 17China Will Reflate More Chart 18Relaxing Anti-Corruption Campaign Another Form Of Easing Chart 19Hong Kong Equities Have Farther To Fall We still are long European equities versus Chinese equities and are short the CNY-USD. From a geopolitical point of view, the U.S.-China conflict is intensifying with President Trump’s threat to raise an additional 10% tariff on $300 billion of Chinese imports despite the resumption of talks. In addition, the Hong Kong protests are intensifying, with China’s People’s Liberation Army (PLA) warning that it may have to intervene. There is high potential for violence to erupt, leading to a more heavy-handed approach by Hong Kong security forces and even eventual PLA deployment. This suggests there is downside in the Hang Seng index (Chart 19) – and PLA intervention could lead to broader investor concerns about China’s internal stability and another reason for tensions with the United States and its allies. The U.S.-China conflict is intensifying. Our alarmist view on Taiwan in advance of the January 2020 election is finally taking shape. Not only has the Hong Kong unrest prompted a notable uptick in Taiwanese people’s view of themselves as exclusively Taiwanese (Chart 20), but Beijing has also announced additional restrictions on travel and tourism to Taiwan – an economic sanction that will harm the economy (Chart 21). These actions and escalation in Hong Kong raise the odds that the ruling Democratic Progressive Party will remain in power in Taiwan after January and hence that cross-strait relations (and by extension Sino-American relations) will remain strained and will require a higher risk premium to be built in. The latest trade war escalation could easily spill into strategic saber-rattling, as the U.S. blames China for North Korea’s return to bad behavior and China blames the U.S. for dissent in Hong Kong and likely Taiwan. Chart 21Beijing To Sanction Taiwan Tourism Again The U.S.-China trade negotiations are falling apart at the moment. We had argued that China’s stimulus and stabilization would create a negative reaction from President Trump, who would regret the Osaka ceasefire when he saw that China’s bargaining leverage had improved. This has come to pass, vindicating our 60% odds of an escalation post-G20. The U.S. Commerce Department could still conceivably renew the Temporary General License for U.S. companies to deal with Chinese tech firm Huawei on August 19, in order to create an environment conducive to progress for the next round of trade talks in September, but with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling. China’s new announcements regarding reforms to make local officials more accountable and to make it easier for companies to go bankrupt, including unprofitable “zombie” state-owned enterprises, could be a thinly veiled structural concession to the United States, but it remains to be seen whether these will be implemented and reinforced. Beijing rebooted structural reforms at the nineteenth national party congress but we expect stimulus to overwhelm reform amid trade war. We are converting our long non-Chinese rare earth producers recommendation to a strategic trade, after it hit our 5% stop-loss, as it is supported by our major theme of Sino-American strategic rivalry. The secular nature of this rivalry has been greatly confirmed by the fact that President Trump is now responding to American election dynamics. The U.S. Democratic Party’s primary debates have revealed that the candidates most likely to take on President Trump (Bernie Sanders and Elizabeth Warren) are adopting his hawkish foreign policy and trade policy stance toward China. The frontrunner former Vice President Joe Biden is the exception, as he is maintaining President Obama’s more dovish and multilateral approach. Trump’s clear response is to ensure that he still owns the trade and manufacturing narrative, to call Biden weak on trade, and to prevent the left-wing populists from outflanking him. Short the Hang Seng index as a tactical trade and close long Q1 2020 Brent futures versus Q1 2021 at the market bell tonight.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Maddy Thimont Jack, “A New Prime Minister Intent On No Deal Brexit Can’t Be Stopped By MPs,” May 22, 2019, www.instituteforgovernment.org.uk. 2 See Dominic Walsh, “Would MPs really back a no confidence motion to stop no-deal?” The New Statesman, July 15, 2019, www.newstatesman.com.

Dear Client, Next week I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Amr answers some key questions that clients have been asking about Japan recently: Does the Bank of Japan have any monetary policy ammunition left? How hard will October’s tax hike hit consumption? Has Japan’s corporate governance improved meaningfully? Is there a case for a rerating of Japanese equities? I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Highlights Risk assets are likely to struggle over the next few weeks as investors digest both the decision by President Trump to further raise tariffs on Chinese imports, and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. Despite the bluster from the Trump Administration, a trade deal between the U.S. and China is still more likely than not. The failure to reach a deal would weaken the U.S. economy, hurting Trump’s reelection prospects. Reassuringly, there is scant evidence that the global manufacturing downturn has infected the service sector to any significant degree. This is true not just for the U.S., but for manufacturing-intensive economies such as Germany as well. The share of manufacturing in both GDP and employment has fallen steadily around the world. Manufacturing output has also become less volatile over time, and less correlated with service sector growth. As global manufacturing activity starts to recover later this year, earnings growth will pick up. Stay overweight global equities relative to bonds on a 12-month horizon, while preparing to increase exposure to EM and European stocks. Feature First The Fed, And Then Trump Risk assets got hit by a one-two punch this week. First, the Federal Reserve dashed investors’ hopes for an extended easing cycle. While the Fed did cut rates by 25 basis points and pledged to end its balance sheet runoff in August (two months earlier than previously indicated), Jay Powell’s characterization of the Fed’s current mantra as a “mid-cycle adjustment to policy” suggested that further cuts were far from guaranteed. To reinforce the point, Powell stated that the Fed was not at “the beginning of a lengthy cutting cycle.” “That’s not our perspective now, our outlook,” he added. Contributing to the hawkish backdrop, Esther George, the president of the Kansas City Fed, and Eric Rosengren, the once fairly dovish president of the Boston Fed, voted to keep rates unchanged. Equities initially plunged on Wednesday following Chair Powell’s press conference. Markets rallied back Thursday morning, only to tumble again in the wake of President Trump’s decision to further raise tariffs on Chinese imports. There is no shortage of theories purporting to explain the timing of Trump’s decision. Was he trying to send a message to the Fed that it had better keep easing? Was he annoyed that Elizabeth Warren, Bernie Sanders, and a number of other presidential contenders tried to outflank him on trade during the Democratic debate the prior evening by suggesting he was not protectionist enough? Regardless, risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. While a severe escalation of the trade war would tip the scales towards recession, the risk of such an outcome remains low. Negotiations with China are ongoing. The threat to further raise tariffs in September is consistent with the “maximum pressure” doctrine that has governed Trump’s policy decisions. Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s reelection prospects. The fact that the latest tranche of tariffs, unlike previous ones, will fall mainly on consumer goods could further hurt Trump in the polls. He does not want that. The Manufacturing Cycle: How Low Will It Go? Chart 1The Global Manufacturing Cycle Has Likely Reached A Bottom Trade tensions have undoubtedly exacerbated the global manufacturing downturn. However, trade policy hasn't been the only culprit, as evidenced by the fact that manufacturing activity began to decelerate even before the trade war heated up in earnest. As we explained in detail last week,1 manufacturing activity tends to follow a “natural cycle” lasting about three years, with output growth rising for the first 18 months, and falling for the next 18 months (Chart 1). The latest downleg began at the start of 2018. Thus, as long as the trade war does not spiral out of control, we should soon see a bottom in the manufacturing cycle based on this timing. For now, the evidence for such a bottom remains mixed. It is encouraging that data released this week showed an improvement in the Chinese Caixin Manufacturing PMI and a slight uptick in the new orders component of the U.S. ISM manufacturing survey. Nevertheless, both surveys remain weak in absolute terms. Meanwhile, the European PMIs have continued to deteriorate, taking the global manufacturing PMI down to 49.3 in July, the lowest level since October 2012.  What one can say more definitively is that at least so far, the manufacturing downturn has not infected the service sector to any significant degree (Chart 2). The U.S. non-manufacturing ISM will be released on Monday, but the June reading of 55.1, while below year-ago levels, was still in the middle of its historic range (Chart 3). Chart 2AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 2BThe Service Sector Has Softened Much Less Than Manufacturing (II)   Chart 3U.S. ISM Non-Manufacturing Still Close To Its Historic Average Strong demand for services has underpinned U.S. employment growth which, in turn, has supported consumption growth. Real PCE rose by 4.3% in Q2. The jump in the Conference Board’s index of consumer confidence in July suggests that U.S. consumers remain upbeat. Notably, the services PMI has increased in the euro area this year, even as the manufacturing sector has weakened there. In Germany, where the manufacturing PMI plunged to 43.2 in July, the non-manufacturing PMI still managed to clock in at 55.4, up from 51.8 in December 2018. Manufacturing: A Canary In The Coal Mine Or Just A Coal Mine? The fact that the overall German economy has not come crashing down despite its high reliance on manufacturing is reassuring. Nevertheless, many investors remain convinced that it is just a matter of time before manufacturing woes precipitate a broad-based economic downturn. Such concerns are well founded if protectionism causes the entire global trading system to come crashing down. However, provided that this does not occur, it is unlikely that slower manufacturing growth, in and of itself, will trigger a recession. Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. Contrary to conventional wisdom, there is little evidence that manufacturing leads the broader economy. Chart 4 clearly shows that manufacturing output tracks overall real GDP growth, with no clear lead-lag relationship. Chart 4Manufacturing Activity Moves In Sync With The Broad Economy Granted, manufacturing growth is more volatile than GDP growth, but that is simply because of the nature of manufacturing production. More than half of manufacturing output consists of durable goods. Purchases of durable goods tend to be lumpy over time. When unemployment starts to rise, households typically postpone purchases of, say, refrigerators and automobiles, while businesses postpone purchases of capital goods. As inventories pile up, manufacturers respond by cutting output. The opposite happens during expansions. The Declining Role Of Manufacturing In The Economy As a share of GDP, global manufacturing output currently stands at 16%. The manufacturing share has been trending lower in most countries (Chart 5). In the U.S., where the data goes back much further, manufacturing output has declined from over 25% of GDP in the 1950s to 11% of GDP at present. The share of manufacturing jobs in total employment has dropped in tandem (Chart 6). Chart 5The Declining Role Of Manufacturing Is A Global Phenomenon Chart 6The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling   The volatility of manufacturing growth rates has also fallen over time. This has occurred partly because of better inventory management techniques. Chart 7 shows that the ratio of real nonfarm inventories-to-domestic sales of goods and structures has been trending lower for the past 40 years. Diminished fears of oil embargos and price controls, which were rampant during the 1970s, have also allowed inventory levels to come down. Chart 7A Structural Decline In The Inventories-To-Sales Ratio Starting In The Early 1980s As manufacturing has become a smaller and less volatile part of the economy, its impact on the service sector has diminished. In fact, we estimate that all of the reduction in the variance of U.S. private sector GDP growth over the past 50 years can be attributed to a smaller contribution from the goods-producing sector, as well as a decline in the correlation between goods-producing and service-producing industries (Chart 8). Investment Conclusions Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. As long as the trade war does not boil over, global manufacturing activity should recover during the remainder of this year, boosting corporate earnings in the process. More cyclically-oriented stock markets and sectors will benefit the most. Non-U.S. stocks have the advantage of trading at a substantial discount to their U.S. peers. Chart 9 shows that U.S. stocks trade at 17.5-times forward earnings, while non-U.S. stocks trade at only 13.5-times forward earnings. We expect to upgrade European and EM equities over the coming months. Chart 9AEquities: Better Valuations Outside The U.S. (I) Chart 9BEquities: Better Valuations Outside The U.S. (II) Better global growth prospects should cause the dollar to weaken. Stronger growth should also allow government bond yields to rise and yield curves to steepen. Investors should favor stocks over bonds for the next 12 months. Housekeeping: We were stopped out of our long EUR/JPY trade for a loss of 5%. We will consider reopening this trade once market volatility settles down.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Chart 1Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data   Chart 5China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Much like the rest of the global economy, oil markets await the lift in demand that fiscal and monetary stimulus have delivered in the past. As the debate among BCA Research’s strategists demonstrated, this is not a given. Uncertainty over the effectiveness of these policy responses will remain elevated as 2H19 evolves.1 For our part, we expect global stimulus – led by easing financial conditions in the U.S. and China – will reboot demand. On the supply side, we expect OPEC 2.0 production discipline and capital-constrained U.S. shale-oil production to keep output growth just below demand growth for the next year (Chart of the Week, top panel).2 Markets arguably have not been on the same page as us for the past two months or so, and appear to be pricing in supply-demand assumptions similar to those contained in the U.S. EIA’s latest Short-term Energy Outlook (STEO).3 These generate lower forecasts – $61/bbl and $57/bbl – than the $75/bbl and $70/bbl we expect for Brent and WTI next year, when we run them through our fundamental econometric model (Chart 2). Chart of the WeekOil Supply - Demand Balance Will Continue To Tighten We argue below the EIA’s assumptions are consistent with current price levels, but inconsistent with current Brent and WTI forward curves. We remain long September – December 2019 Brent vs. short September – December 2020 Brent, which is up 76% since inception February 28, 2019, and long 1Q20 vs. 1Q21 Brent, which is up 39% since inception July 18, 2019, in anticipation of steeper backwardations. We also expect the combination of global fiscal and monetary stimulus, along with the aforementioned production constraints, will lift price levels in line with our forecasts. Highlights Energy: Overweight. In line with our expectation, U.S. crude oil inventories drew 8.5mm barrels last week, posting a record seventh consecutive draw. Last week’s inventory drawdown follows a massive draw in crude oil of close to 11mm barrels the previous week. Base Metals: Neutral. Spot treatment and refining charges (TC/RC) for copper fell to $51.20/MT last week, the lowest reading since the launch of Fastmarkets MB’s Asia-Pacific index in 2013. This is consistent with tighter spot supplies – low TC/RC levels mean demand for spot refining services is weak due to low concentrate supply. Our long Dec19 $3.00/lb calls vs. short Dec19 $3.30/lb call on the COMEX was stopped out after hitting our -15% stop-loss limit. We remain bullish and will re-visit this recommendation in the near future. Precious Metals: Neutral. Gold prices remain well supported by global monetary accommodation, as seen this week following the Fed’s decision to lower its policy rate by 25bps to 2.25%. We expect another “insurance cut” later this year, and remain long gold, which is up 12% this year as central banks scramble to redress tightening financial conditions globally. Ags/Softs: Underweight. 54% of the U.S. soybean crop was rated in good or excellent condition in states accounting for 95% of bean acreage. Last year at this time, 70% of the crop was rated good or excellent, according to the USDA’s Crop Progress Report. Feature The oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. Easing financial conditions in the U.S. and China, along with higher fiscal outlays globally, are necessary and likely sufficient to reboot global oil demand, in our assessment of fundamentals.4 On the supply side, our modeling assumes OPEC 2.0’s production discipline and capital-constrained U.S. shale-oil production will be sufficient to keep output growth just below demand growth for the next year.5 Chart 2Oil Markets Pricing Weaker Fundamentals Than BCA Expects In our modeling, these supply-demand effects combine to lift prices, and to further backwardate the Brent and WTI forward curves as global storage levels fall, as the top panel of Chart 2 shows. However, as the bottom panel of Chart 2 illustrates, the oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. The EIA assumes demand growth of 1.1mm b/d this year, versus our assumption of 1.25mm b/d, and 1.4mm b/d next year, versus our 1.5mm b/d assumption. When we push the EIA’s assumptions through our fundamental supply-demand-inventory model, we get average Brent prices of $64/bbl this year and $61/bbl in 2020, versus our expectations of $70/bbl this year and $75/bbl next year for Brent.6 For WTI, the EIA’s fundamentals produce prices of $57/bbl in 2019 and $57/bbl in 2020, versus our expectation of $63/bbl and $70/bbl. Whither Storage? The EIA’s supply-demand fundamentals produce price levels closer to where the market is trading currently, when we run them through our fundamental model. However, they are not consistent with forward-curve dynamics, which presently are backwardated. Using the EIA’s supply and demand assumptions for this year and next in our econometric model produces an increase in oil inventories, which grows next year, as opposed to our expectation inventories will shrink over the course of the next year (Chart 3, bottom panel). If the EIA’s expectation for inventories was shared by market participants, Brent and WTI forward curves would be in contango, not backwardation as they are presently. In this respect, our estimates are more consistent with current forward-curve dynamics (Chart 3, top panel). Chart 3Inventories Swell Assuming EIA's Supply-Demand Fundamentals Chart 4Crude Inventories' Days-Forward-Cover This also can be seen in an analysis of days-forward-cover (DFC) dynamics, in which we compare deviations from the five-year average (trend) number of days’ worth of demand that can be covered by current inventory levels (Chart 4). Our assumptions produce deviations that align with the differentials between prompt and deferred futures contracts, which measures the backwardation and contango in Brent and WTI markets. The implied DFC ratio that falls out of running the EIA’s supply-demand assumptions in our fundamental model shows inventories in 2020 level out, even as market participants continue to price in a backwardated forward curve for Brent and WTI.7 If we are correct in our assessment of inventories, Brent volatility will increase next year as inventories and DFC fall (Chart 5).   Whither Global Trade, Manufacturing? As we’ve noted above, the next few months will provide important information to markets and policymakers alike, as both wait to see whether the concerted monetary policy efforts aimed at reviving the real economy – manufacturing, in particular – will be effective. As an aside, uncertainty regarding the effectiveness of what, in the not-too-distant past, was considered standard macroeconomic stimulus is not restricted to market participants and practitioners. Central banks, and the economics profession itself are in the midst of a fundamental rethink of its foundational assumptions and models, and will be dialed in on this entire process.8 We continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. The global manufacturing slowdown in 1H19 is confirmed in EM trade data (Chart 6). This has the potential to continue if the Sino-U.S. trade war retards capex and durable-goods spending. The IMF notes the linkage between manufacturing and global trade exists because trade includes a lot of durables, which are energy-intensive in their production and transportation.9 Again, the big unknown here is whether the fiscal and monetary stimulus in systematically important economies will be sufficient to revive manufacturing globally and commodity demand, particularly for energy. There is enough cognitive dissonance around the effectiveness of monetary policy – and the channels through which it operates – to give even a hardened monetarist pause. If, as we expect, U.S. monetary stimulus succeeds in weakening the USD, global trade and EM GDP levels can be expected to increase.10 This will be supportive of commodity demand generally, oil demand in particular. In a simulation of oil prices as a function of the broad trade-weighted USD, we found Brent prices could rally sharply on a 10% depreciation between now and end-2020 (Chart 7). Chart 6Fiscal and Monetary Stimulus Will Lift Global Trade and Manufacturing Chart 7Fed Policy Should Weaken USD, Boost Oil Demand Such a rally is unlikely to occur due to USD weakness alone, given the mitigating factors observed in recent excursions above $80 Brent. OPEC 2.0 likely would raise production as prices moved through $80/bbl, and we expect demand destruction in EM economies would quickly follow, due to the removal of fuel subsidies in many EM economies. These supply-demand responses would push prices lower after a few months. However, this exercise is worthwhile in forming an expectation around successful Fed stimulus, given the long-term equilibrium between the broad USD TWIB and oil prices since 2000. This analysis also suggests there is a role for OPEC 2.0 in increasing production, if systematically important central banks succeed in reviving global demand, and the Fed can lower the USD TWIB. Keeping production too low at that point would be self-defeating for the coalition. Successfully managing this balance would support EM GDP growth and, in so doing, lift commodity demand. Bottom Line: Oil prices are trading to lower expected levels of demand and higher supply than we currently are using in our forecasts. However, we continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. As such, we are maintaining our expectation Brent crude will average $70 and $75/bbl this year and next, with WTI trading $7 and $5/bbl lower, respectively. We also expect these forces to steepen the backwardation in Brent and WTI forward curves this year and next. Big policy issues – the Sino-U.S. trade war, U.S.- Iran tensions in the Persian Gulf, uncertainty around how the crisis in Venezuela is resolved – still dog markets, as do persistent doubts re the effectiveness of monetary policy.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see What Goes On Between Those Walls? BCA’s Diverging Views In The Open, a Special Report published by BCA Research July 19, 2019. It is available at bca.bcaresearch.com. 2      OPEC 2.0 is the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was founded in 2016 to reduce global oil inventory levels bloated by a market-share war launched by the original OPEC cartel in 2014. Backwardation is a term of art in commodity markets, which describes a forward curve in which prompt prices exceed deferred prices. The opposite of backwardation is contango. 3      The U.S. Energy Information Administration’s Short-term Energy Outlook is published monthly. 4      Please see Weak 1H19 Oil Demand Data Fuels Market Uncertainty, published July 18, 2019, for our latest forecast. 5      NB: Our forecast for U.S. shale-oil production includes the drawdown of excess drilled-but-uncompleted (DUC) wells, especially in the Permian as pipeline constraints are removed this year. Recent reports have suggested DUC excess inventory is over-estimated in EIA data we use in our models, and that more wells than actually are reported by the EIA are required to produce the volumes reported for the Permian Basin. Please see Analytics Firm: Permian Fracturing Work Underreported by 21% in 2018 published by the Journal of Petroleum Engineering July 24, 2019. 6      The EIA’s forecast calls for Brent to average $67/bbl in 2H19 and for all of 2020, and for WTI to trade $5/bbl and $4/bbl under Brent in 2H19 and 2020, respectively. For 2H19, we expect Brent to trade at $74/bbl; we expect WTI to trade $7/bbl below Brent in 2H19 and $5/bbl lower in 2020. 7      We assume OPEC 2.0 will need to increase production in 2H20, to keep inventories from falling so low that Brent prices risk breaching $80 - $85/bbl, which we view as the no-go zone the producer coalition is most sensitive to. 8      Please see Rebuilding macroeconomic theory Volume 34, Issue 1-2 of the Spring-Summer 2018 issue of the Oxford Economic Policy Review for an excellent treatment of this effort. The Fed also is examining how it conducts monetary policy, in an effort led by Vice Chair Richard Clarida. The initial research goals were laid out in November 2018, when the Fed announced it would be conducting a comprehensive review of its monetary policy strategy, tools, and communication practices. In June of this year, the Fed followed through with a two-day symposium to discuss many of the topics we routinely address in our publications. Prof. Maurice Obstfeld of Berkeley’s Global Dimensions of U.S. Monetary Policy was an insightful paper re how U.S. monetary policy affects global growth; Prof. Kristin Forbes of MIT’s discussion also was excellent, and highlighted the role of commodity markets in this framework. 9      Please see Still Sluggish Global Growth in the IMF’s World Economic Outlook Update, published July 23, 2019. The Fund lowered its global growth forecast slightly, and cautioned, "GDP releases so far this year, together with generally softening inflation, point to weaker-than-anticipated global activity. Investment and demand for consumer durables have been subdued across advanced and emerging market economies as firms and households continue to hold back on long-term spending. Accordingly, global trade, which is intensive in machinery and consumer durables, remains sluggish. The projected growth pickup in 2020 is precarious, presuming stabilization in currently stressed emerging market and developing economies and progress toward resolving trade policy differences." 10     These variables are intimately connected. Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah published by BCA Research’s Global Investment Strategy June 28, 2019, for our House view on global growth, interest rates and the expected evolution of the USD. It is available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades  

Special Report

Highlights China’s infrastructure investment growth rate could rebound moderately from its current nominal 3% pace, but will remain well below the double-digit rate it has registered for most of the past decade.  A lack of funding for local governments and their financing vehicles will somewhat cap the upside in infrastructure fixed-asset investment (FAI) in the next six to nine months. Special bond issuance will be insufficient to ensuring a major recovery in infrastructure spending. Investors should tread cautiously on infrastructure plays in financial markets. Feature Chart I-1Chinese Infrastructure Investment: Double-Digit Growth Again? Nominal infrastructure investment growth in China has slowed from over 15% in 2017 to 3% currently (Chart I-1). This is the weakest growth rate since 2005 excluding the late 2011-early 2012 period. Over the past decade, each time the Chinese economy experienced a considerable slowdown, infrastructure construction was ramped up to revive growth. Infrastructure spending growth skyrocketed in 2009 and was also boosted in 2012. In 2015-2016, it was not allowed to decelerate with the issuance of nearly RMB 2 trillion of special infrastructure bonds. This time the government has also reacted. Since mid-2018, the Chinese authorities have dramatically raised local governments’ special bonds balance limits, prompted local governments to front-load their issuance this year, and also encouraged the private sector to participate in public-private partnership (PPP) infrastructure projects. Will Chinese infrastructure FAI growth accelerate over the next six to nine months from its current nominal 3% pace to double digits? The short answer is no. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. For purposes of this report, the composition of “infrastructure” includes three categories – (1) Transport, Storage and Postal Service, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas & Water Production and Supply. Chart I-2 presents the breakdown of the nominal infrastructure FAI by category. Funding Constraint Preceding both the 2011-2012 and 2018 infrastructure investment slumps, the Chinese central government increased its scrutiny on local government debt and tightened funding conditions for infrastructure projects. As a result, all three categories of infrastructure spending experienced a sharp deceleration (Chart I-3). Overall, financing and qualitative limitations that Beijing imposes on local government infrastructure spending hold the key to the outlook. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. Looking forward, without a considerable recovery in available financing, there will be no meaningful rebound in Chinese infrastructure investment and construction activity. For now, we are not very optimistic on financing. Chart I-4 shows the breakdown of the major funding sources of Chinese infrastructure investment. All of them are likely to face considerable funding constraints over the next six to nine months. Chart I-3Chinese Infrastructure Investment Growth Has Decelerated Across The Board   1. Self-Raised Funds Self-raised funds contribute nearly 60% of overall infrastructure funding. They include net local government special bond issuance, PPP financing and government-managed funds’ (GMFs) revenues excluding proceeds from special bond issuance. A. Local government special bond issuance, which is exclusively used to fund infrastructure projects, has been the major source of financing for local governments in the past 12 months. The authorities significantly boosted net local government bond issuance to RMB 1.2 trillion in the first six months of this year from only RMB 361 billion in the same period in 2018. However, the amount of special bond issuance in the second half of this year will unlikely be significant enough to boost infrastructure FAI greatly. First, the central government has not only set a limit on the aggregate local government special bond balance, but it also set limits for each of the 31 provinces/provincial-level cities.1 In the past three years, nearly all provinces did not use up their special bond issuance quotas. This resulted in an outstanding aggregate amount of special bonds of only about 85% of the limit.2 In both 2017 and 2018, local governments were left with RMB 1.1 trillion special bond issuance quota unused for that year. Second, based on the limit on outstanding amount special bonds set by the central government for the end of 2019, local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of this year. In comparison, in 2018, the issuance was heavily concentrated in the second half of the year with RMB 1.6 trillion. Our estimate shows there will be only RMB 400-600 billion increase in net total special bond issuance in 2019 versus 2018.3 This will translate into a merely 2-3% growth in Chinese infrastructure investment. Third, net local government special bond issuance made up only 15% of overall infrastructure FAI over the past 12 months. Hence, there is still a huge financing gap to be filled (Chart I-5). B. Public-private partnerships (PPP) are unlikely to meet the financing shortage either. PPPs have become an important financing model for Chinese local governments to fund infrastructure investments since 2014. Nevertheless, to control rising local government debt risks, the central government has tightened regulations on PPP projects since early last year. A series of tightened rules have resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPPs contributions to total infrastructure FAI have plunged from over 30% in 2017 to 10% currently (Chart I-6). Chart I-5Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Chart I-6Public-Private Partnerships: Too Small To Meet The Financing Shortage   So far, the rules on PPP projects on local governments remain tight. In March, the central government tightened its rule on local government participation in PPP projects. The new rule states that, if a local government has already spent more than 5% of its overall general expenditures on PPP projects excluding sewage and waste disposal PPP projects, it will not be allowed to invest in any new PPP projects. Before March, the threshold was over 10%. In early July, the National Development and Reform Commission (NDRC) demanded all PPP projects undertake a thorough feasibility study. The NDRC emphasized that PPP projects that do not follow standard procedures will not be allowed. Chart I-7Government-Managed Funds: Headwinds From Falling Land Sales C. Government-managed funds (GMF) excluding special bond issuance accounts, which contribute about 15% of overall infrastructure financing, are also facing constraints. According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures of the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. Land sales by local governments are one major revenue source for GMFs. Contracting property floor space sold is likely to depress real estate developers’ land purchases, further reducing local governments’ revenues from selling land (Chart I-7). This will curb local governments’ ability to finance their infrastructure projects through GMFs. 2. Domestic Loans Domestic loans contribute to about 15% of overall infrastructure financing. Infrastructure projects are generally long term in nature. Presently, the impulse of non-household medium- and long-term (MLT) lending has stabilized but has not yet improved (Chart I-8). While not all of MLT loans are used for infrastructure, sluggish MLT lending reflects commercial banks’ reluctance to finance infrastructure projects. We believe a decelerating economy, mounting local government debt, and often-low returns on infrastructure projects will continue to constrain loan funding of infrastructure projects from both banks and the private sector. 3. General Government Budget The general government budget (which includes central and local governments) accounts for about 15% of overall infrastructure financing. The general budget is also facing headwinds from declining revenue due to recent tax cuts and lower corporate profit growth (Chart I-9). Chart I-8Sluggish Medium/Long-Term Bank Lending Chart I-9Government General Budget: Large Deficit   Bottom Line: Funding constraints will likely linger, making any recovery in Chinese infrastructure investment growth moderate over the next six to nine months. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. While local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of 2019, it would be well below the RMB 1.4 trillion of special bond issuance that was rolled out in the second half of 2018. FAI In Transportation: In Nominal Terms… The transportation sector accounts for about 31% of total Chinese infrastructure investment. It includes railway, highway, urban public transit, air and water transport. Table I-1 shows the 13th five-year (2016-2020) transportation investment plan released by the government in February 2017,4 which excludes urban public transit. The authorities planned to invest RMB 15 trillion in the transportation sector over the five-year period between 2016 and 2020, with highways accounting for over half of the investment, followed by railways (23%), air transportation (4.3%) and water transportation (3.3%). The table also shows our calculation of the realized investment amount in these four sub-sectors for the period of January 2016 to June 2019. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. Table I-1 suggests the remaining FAI for the transportation sector for the July 2019 to December 2020 period will be considerably smaller than the FAI amount over the past 18 months. This entails a major drag on infrastructure investment at least over the next 18 months. It is important to emphasize that this is conditional on the central planners in Beijing sticking to their five-year plan for infrastructure FAI. As of now, there has been no announcement of revisions to these five-year FAI targets. Bottom Line: China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. …And Real Terms Table I-2 summarizes the 2020 targets for major Chinese infrastructure development (urban rail transit, railway, highway and airport) in real terms. Chart I-10Transportation 2020 Targets: Not Far Away In real terms, the annual growth of transportation infrastructure will likely be 4.2% in both 2019 and 2020. We illustrated in the previous section that the five-year budget plan had been front-loaded, leaving a very small budget for transportation investment over the next 18 months. This may suggest that without considerably exceeding the budget, transportation infrastructure will fail to achieve the 4.2% annual growth in real terms both this year and next. In brief, more funding should be dispatched/allowed by the central planners in Beijing for infrastructure FAI not to shrink. Second, urban rail transit, high-speed railways, highways and airports will reach their respective 2020 targets, while non-high-speed railway construction will likely be a little bit off its 2020 target. Third, based on the 2020 targets, urban rail transit will enjoy very fast growth over the next one and a half years. Fourth, the growth of high-speed railways and highways will be very low, at around 1-2% in real terms (Chart I-10). Finally, while the number of airports will increase at a faster pace, their contribution to overall infrastructure investment will remain insignificant as they only account for about 1.4% of overall infrastructure investment. Bottom Line: In real terms, transport infrastructure growth will likely be only about 4% over the next six to nine months. Future Infrastructure Investment Focus Urban rail transit, environmental management and public utility management will likely be the major driving forces for Chinese infrastructure investment over the next 18 months. Urban rail transit line length will likely register fast growth of around 10% over the next six to nine months. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management will likely experience continued growth acceleration (Chart I-11). China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. Meanwhile, as the country’s urbanization continues and more townships and city suburbs become urbanized,5 public utility management investment will also grow moderately. Public utility management investment, contributing a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels in the city. Investment Implications Investors should not hold their breath expecting a major upswing in infrastructure FAI and a major rally in related financial markets. Chinese steel demand is sensitive to construction of railways and urban rail transit lines (Chart I-12, top panel). In turn, mainland cement demand is dependent on highway construction (Chart I-12, bottom panel). Chart I-11Environment Management: Will Continue Booming Chart I-12Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand...   Chart I-13...And Steel & Cement Prices At The Margin The infrastructure sector accounts for about 10-15% of total Chinese steel use, and about 30-40% of Chinese cement consumption. Nevertheless, given that we believe Chinese infrastructure spending will only have a moderate recovery, the positive effect on steel and cement prices will be muted as well (Chart I-13). The same holds true for spending on industrial machinery, equipment, chemicals and various materials. Notably, risks to this baseline scenario of a muted recovery are to the downside because of the lack of funding. Barring a substantial increase in the special bond issuance quota this year or a major credit binge, infrastructure FAI growth could in fact stall. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1  Please note that the central government only set the special bond balance limit (not the quota) for local governments. The often-cited “quota” in the news is derived by calculating the difference between the current limit and the previous year’s limit. The “quota” used in this report is the difference between the current special bond balance limit and the actual special bond balance of the previous year end. 2  At the end of 2018, Chinese special bond balance was RMB 7.4 trillion, only 85.8% of the special bond balance limit of RMB 8.6 trillion. This ratio was 84.6% in 2017 and 85.5% in 2016. On average, the ratio was 85.3% in the past three years. 3  Given that the central government is aiming to somewhat stimulate infrastructure spending by increasing special bond issuance, we assume special bond balance at the end of 2019 to reach 88%-90% of the limit (RMB 10.8 trillion) that it has set for 2019. This will be higher than the 85% average of the past three years. In turn, this means that the special bond balance at the end of this year will likely be RMB 9.5-9.7 trillion. Since the balance at the end of last year was RMB 7.4 trillion, this results that net special bond issuance will be around RMB 2.1-2.3 trillion in 2019. Given the net special bond issuance last year was RMB 1.7 trillion, it follows that there will only be a RMB 400-600 billion increase in total special bond issuance in 2019 versus 2018. 4  Please see www.gov.cn/xinwen/2017-02/28/content_5171576.htm, published February 28, 2017, by the Chinese central government website. 5  Please see Emerging Markets Strategy/China Investment Strategy Special Report “Industrialization-Driven Urbanization In China Is Losing Steam,” dated January 2, 2019, available on ems.bcaresearch.com

Highlights Fed: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional “insurance” cut in September. ECB: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. Fixed Income Strategy: The Fed is more likely to disappoint deeply dovish market expectations than the ECB over the next 6-12 months. European fixed income should outperform U.S. equivalents, both for government bonds and corporate debt, especially with the ECB ready to buy bonds again. Stay overweight Bunds vs Treasuries and euro area corporate debt vs U.S. equivalents on a USD-hedged basis. Feature Chart of the WeekData To Satisfy Both The Optimists & Pessimists In normal years, the final days of July are a quiet time for financial markets, with investors focused on preparations for August vacations rather than fretting about the performance of their portfolios. This is not one of those years. Central banks are springing into action to combat a global manufacturing downturn, creating a peculiar divergence of market price signals - elevated stock prices and depressed bond yields. BCA exposed our own internal debate on the growth outlook, and the implications for financial markets, in a recent Special Report.1 Our latest discussions with clients show similar splits within investment committees. While Global Fixed Income Strategy is in the optimist camp at BCA, we do recognize that there is enough news and data at the moment to satisfy both bullish and bearish investors (Chart of the Week). The growth bears can point to the continued deceleration of global trade and manufacturing data, with our global PMI indicator now sitting below the 2015/16 lows. The bulls, on the other hand, can highlight the bottoming of forward-looking data like our global leading economic indicator or the pickup in Chinese credit growth. Most importantly, the bulls are having a very enjoyable summer with interest rate cuts expected from the Fed and ECB, and the latter likely to restart quantitative easing. In this Weekly Report, we focus on monetary policy – specifically, the outlook for the Fed and ECB’s next moves over the next few months – and the implications for financial markets. Our conclusion is that the likely policy choices will benefit the relative performance of European fixed income markets versus U.S. equivalents over a 6-12 month horizon. The ECB’s Next Move: See You In September Chart 2A "Manufacturing-Only" Slump The global trade downturn has hit growth in the U.S. and Europe in a similar fashion, with PMI data showing substantially weaker activity in manufacturing compared to more domestically focused service industries (Chart 2). In Europe, there is an unprecedented divergence, with the services PMI rising and the manufacturing PMI plummeting over the past several months. At his press conference after last week’s monetary policy meeting, ECB President Mario Draghi described the European manufacturing data as “getting worse and worse”. He is right, as evidenced by the downtrends seen in other cyclical data like the ZEW and IFO surveys. European bond markets are betting that the ECB will focus on the manufacturing side of the export-heavy euro area economies and will soon ease monetary policy. Draghi gave strong indications that the ECB will deliver a package of easing measures at the September policy meeting, ranging from interest rate cuts to restarting the Asset Purchase Program (APP) for both government and corporate debt. Bond investors have been making large bets on the ECB delivering a big easing, with European bond yields plummeting to new cyclical lows. Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. The surge in the amount of debt trading at negative yields has gotten the attention of the market. By our count, 53% of all government bonds in the developed economies are now trading with a negative yield, with much of those in Europe (Chart 3). Investors are reaching for anything with a positive yield, including formerly toxic debt like Italian and Greek government bonds, with the benchmark 10-year yields in those markets now down to 1.6% and 2.1%, respectively. The rally has extended into spread product, creating oddities such as shorter-maturity EUR-denominated emerging market bonds – some with credit ratings below investment grade – trading at negative yields.2 From a longer-term perspective, the European bond rally continues a trend seen over the past decade where the relative performance of European equities versus government bonds, a.k.a. the stock-to-bond ratio, has been anemic compared to the similar metric in the U.S. (Chart 4). Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. Chart 3Positive Yields Are Getting Harder To Find Chart 4Structural Market Pessimism On Europe From a cyclical perspective, the case for a comprehensive easing package from the ECB now is a strong one, for several reasons: There is a broad-based slowing of growth and inflation within the euro area. Our diffusion indices of individual country data for real GDP growth and the OECD’s leading economic indicators show that the overwhelming majority of euro area nations are seeing slowing growth (Chart 5). Similar readings coincided with multiple interest rate cuts in 2001, 2008/09 and 2012. Chart 5Good Reasons For An ECB Rate Cut Chart 6Can The ECB Stop A Credit Crunch In Italy? Realized inflation and inflation expectations remain muted. Our diffusion indices for inflation rates among euro area countries are more mixed, with almost all nations actually seeing a slight uptick in core inflation over the past three months (bottom panel). Yet given the plunge in market-based inflation expectations, with the 5-year/5-year forward EUR CPI swap rate now down to 1.35%, the ECB must focus on trying to put a floor under growth to stabilize inflation expectations. Banks are starting to tighten lending standards. The ECB’s latest Bank Lending Survey showed a sharp tightening of lending standards to businesses during Q2/2019 (Chart 6) in France and, more worryingly, Italy where loan growth has been contracting on a year-over-year basis. The ECB already took action back in March to introduce a new targeted bank funding program (TLTRO3), largely to prevent a possible credit crunch in Italy where cheap ECB loans have funded 10% of total Italian bank lending. Yet with Italian banks already tightening lending standards to domestic borrowers, the ECB must take other actions to fight off a deeper contraction in Italian corporate loans. So what can the ECB plausibly do to ease monetary conditions that are already very loose? Cut the deposit rate. Given the ECB’s large balance sheet, swollen by asset purchases, the deposit rate on the excess reserves of banks is now effectively the ECB’s main policy rate. The deposit rate is currently -0.40%, and the ECB is concerned about the impact on European bank profitability by pushing that rate even deeper into negative territory. Draghi noted in his press conference last week that the ECB would consider “tiering” interest rates on excess deposits – essentially, exempting portions of European banks’ excess reserves from being charged negative deposit rates – to help offset the hit to bank profits from negative rates. Chart 7The ECB Can Help Finance European Companies Tiering has been introduced in other countries with negative deposit rates (Japan, Switzerland, Denmark), with limited impacts on bank profitability. The experience of those countries, however, suggests that an introduction of tiering by the ECB could put a floor under interest rate expectations, as it would indicate that additional rate cuts would be too damaging for European bank profitability to be considered by the ECB. For that reason, the ECB could decide to cut rates in September, but without tiering to ensure the maximum effect on European interest rates and bond yields. Restart the Asset Purchase Program (APP). This option is the most intriguing, as it would be a more direct way for the ECB to directly lower the cost of borrowing for European companies where credit conditions are becoming tighter. During the corporate bond buying phase of the APP in 2016-2018, the ECB was not only buying bonds in the secondary market but was buying corporates in the primary (new issue) market. At the peak, the central bank was buying around 18% of all the primary issuance by euro area companies eligible for the APP (Chart 7). This allowed many smaller European companies that relied entirely on bank loans to begin issuing publicly traded corporate bonds to diversify their sources of funding, with the ECB as a guaranteed buyer – in some cases, at interest rates even lower than corporate bank lending rates. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance.  Chart 8Markets Discounting New ECB Corporate Bond Purchases? Investors seem to have already priced in some expectation of a resumption of the ECB’s corporate bond buying program, as euro area credit spreads have tightened sharply despite weakening economic growth (Chart 8). The spread tightening has occurred across all countries and investment grade credit tiers, pushing valuations back to towards the levels seen during the height of the ECB’s last period of corporate bond buying in 2017. The ECB will likely have to start out fairly aggressively with its pace of corporate bond buying, likely with more than €10bn/month, to justify current valuations. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance. Bottom Line: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. The Fed’s Next Moves: Insurance Cuts In July & September, No More After That The latest batch of data from the U.S. suggests that tomorrow’s widely-expected Fed rate cut will not be the start of a full-blown easing cycle. Expect a 25bp cut, with forward guidance suggesting another 25bps in September to protect against the adverse effects on the U.S. from any additional trade policy uncertainty and the associated deterioration of non-U.S. economic growth. Any further easing beyond that is unnecessary given the current state of U.S. growth and inflation. While the year-over-year growth rates of real GDP and core durable goods orders have slowed, the annualized changes over the past six months have shown some reacceleration (Chart 9). Consumer spending has also perked up after the sharp drop fueled by the government shutdown back in January, while the lagged impact of the sharp fall in mortgage rates over the past year should provide a moderate boost to housing activity. A similar dynamic is seen on the inflation front, where the marginal 6-month annualized rate of change of core PCE inflation has picked up to 2% (Chart 10). Less volatile inflation gauges like the Dallas Fed’s trimmed mean core PCE inflation rate are also at 2%. Furthermore, one of the main causes of the unexpected downturn in core PCE inflation in 2018, the Financial Services component, is already rebounding – a trend that will continue given the U.S. equity market’s strong gains in 2019 (bottom panel). Chart 9U.S. Growth Rebounding Chart 10U.S Inflation Rebounding Look for the Fed to signal a cautious tone tomorrow, but without sounding overly pessimistic on U.S. growth prospects. Bottom Line: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional cut in September. Additional moves after that are unlikely, given signs of reaccelerating momentum in U.S. economic growth and inflation. Investment Implications For The U.S. Versus Europe Over The Next 6-12 Months Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents.  Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents. Chart 11Too Soon To See An Export-Led Rebound In Europe The European economic downturn seen over the past year has come almost entirely from the trade side, when looking at the contributions to real GDP growth from net exports and domestic demand (Chart 11). This is also consistent with the manufacturing/services gap discussed earlier in this report, given the large share of manufactured goods in overall euro area exports. China will play a huge role in determining the future path of European economic growth through the trade channel, and already the pickup in Chinese credit growth is heralding a future rebound in European exports to China (third panel). A recovery in euro area exports to other countries besides China is also in store, based on our global leading economic indicator diffusion index (i.e. the net number of countries seeing a rising leading indicator). Yet given the long lead time before changes in those leading European export indicators and the subsequent growth of European exports – between 9-12 months – an improvement in euro area exports will not be visible in the hard data until late in 2019. It will likely be even longer than that given the additional publishing lags of the export data. Importantly, while the recent headlines have provided grounds for more cautious optimism on U.S.-China trade talks, any breakdown on that front would potentially delay any recovery in euro area exports (even if that is met by a bigger policy stimulus from China). At the moment, the U.S. economy is better positioned to withstand a renewed bout of trade uncertainty than the euro area, even though U.S. growth would take a hit through higher market volatility and tighter financial conditions if investors turn more risk averse on another failure of U.S.-China trade talks. Chart 12Not Much Downside Left For Bond Yields So after looking at the relative outlooks for economic growth in the U.S. and Europe, and the likely paths to be taken by the Fed and ECB, we come up with the following fixed income investment recommendations: Maintain below-benchmark overall global duration exposure: At an overall portfolio level, we continue to recommend a moderate below-benchmark global duration stance (Chart 12). Our global leading economic indicator diffusion index suggests that global real yields should soon bottom. At the same time, the annual rate of change of oil prices will accelerate over the rest of the year simply based on comparisons versus the sharp plunge in energy prices in the latter months of 2018. If the bullish oil forecast of BCA’s commodity strategists comes to fruition, the growth rate of oil prices will be even higher (see the “X” in the middle panel of Chart 12). Given the correlations between market-based inflation expectations and oil prices, a rebound in oil on a rate of change basis should put a floor under the inflation expectations component of government bond yields in the developed markets. Expect a rebound in the Treasury/Bund spread: The ECB is more likely to deliver on the policy expectations for the next twelve months discounted in Overnight Index Swap curves (-22bps of rate cuts) compared to the Fed (-89bps of rate cuts). This suggests that the spread between 10-year U.S. Treasury yields and 10-year German Bund yields is likely to widen, but coming first through higher relative market-based U.S. inflation expectations - a trend that is already starting to unfold (Chart 13).   ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Favor euro area corporates versus U.S. corporates: ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Another factor supporting European corporates is the better state of financial health among euro area companies, according to our Corporate Health Monitors (Chart 14). Chart 13Inflation Expectations Bottoming Out, Led By The U.S. The gap between the “bottom-up” versions of the Monitors tracks the spread differentials of the benchmark corporate bond indices quite closely, and is currently pointing to a more solid fundamental underpinning for euro area corporates on a cyclical (6-12 months) horizon. Chart 14Favor Euro Area Corporates Over U.S. Corporates   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open”, dated July 19, 2019, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2019-07-15/em-succumbs-to-sub-zero-epidemic-as-debt-pile-doubles-in-a-weekD The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps