Global

Oil prices will remain volatile as markets work through the lingering effects of tighter financial conditions prevailing last year, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand growth (Chart of the Week). In 2H19, globally accommodative monetary policy and fiscal stimulus will revive demand for industrial commodities, particularly in EM economies. This will be most apparent in oil markets, where we continue to expect demand growth to strengthen going into 2020, aided in part by a weaker USD. On the supply side, this week’s extension of OPEC 2.0’s production cuts into 1Q20 means growth will remain constrained. Prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand.1 We continue to expect Brent to average $73/bbl this year and $75/bbl next, respectively. We expect WTI to trade $7/bbl and $5/bbl below that this year and next. Chart of the WeekEasing Financial Conditions Will Spur Oil Demand Highlights Energy: Overweight.  Venezuela’s oil production reportedly recovered to 1.1mm b/d in June.  Most of the increased production found its way to China, which accounted for just under 60% of crude and product exports.2  Given its modus operandi, we believe OPEC 2.0 likely will accommodate higher production in Venezuela by reducing production in other member states, keeping overall output relatively constant. Base Metals: Neutral.  Copper treatment and refining charges fell to new lows at the end of last week, with Fastmarkets MB’s Asia – Pacific TC/RC index recording its lowest level on record at $52.40/MT ($0.0524/lb).3  TC/RC levels fall when supplies are low, as refiners have to discount their services to attract concentrate supplies.  Elsewhere, workers at Codelco’s Chuquicamata copper mine agreed to a new contract last week, ending a brief strike.  Precious Metals: Neutral.  Gold’s rally resumed this week, reflecting investors’ expectations for expanded central-bank accommodation globally, which, all else equal, will keep interest rates lower for longer. The Fed's dovish turn, in particular, will weaken the USD later this year, which will be positive for EM commodity demand, the engine for commodity demand growth globally. Ags/Softs: Underweight.  The USDA reported 56% of corn in the ground was in good to excellent condition last week, vs. 76% of the crop last year.  For soybeans, 54% of the U.S. crop was in good or excellent condition, vs. 71% last year.  The USDA’s Crop Progress reports cover 92% and 95% of total acreage planted in the U.S., respectively. Feature Oil prices will remain volatile over the short term, as markets transition from tighter monetary conditions to a more accommodative global backdrop (Chart 2). Based on our research into the drivers of oil-price volatility, this should translate into a less stressful pricing environment for industrial commodities generally, base metals and oil in particular (Chart 3).4 Chart 2Volatility Indicators Are Moderating Chart 3Signaling Oil Price Volatility Will Fall Much of the current oil-price volatility is being driven by worries over damage to aggregate global demand and growth expectations in the wake of the Sino-U.S. trade war, and by what now appears to be a too-aggressive posture by central banks implementing rates-normalization policies last year. Both of these can affect consumption and investment locally and globally.5 Fear That Real Demand Will Weaken At present, any indication real demand is faltering – e.g., weaker manufacturing PMIs – gives industrial commodities an excuse to sell off (Chart 4). In the case of the Sino-U.S. trade war, presidents Xi and Trump appear to have agreed to re-start trade negotiations. Markets are not going to be terribly concerned with the specifics of a trade deal between the U.S. and China, but it does appear some rollback in U.S. tariffs will be necessary for a trade deal – perhaps in exchange for greater access to Chinese markets. However, our geopolitical strategists make the odds of a trade deal by the time U.S. elections roll around 1:3. Our colleagues in BCA Research’s Global Investment Strategy note, “The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a ‘small’ trade war and a ‘moderate’ trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system.”6 As for monetary policy, major central banks are embarked on a coordinated effort to reverse falling inflation expectations, and will be vigorously stimulating their money supply and credit growth over the balance of the year. In addition, fiscal stimulus globally – in the U.S. and China most prominently – will boost real demand for industrial commodities, particularly oil and base metals.7 Monetary and fiscal stimulus operates with a lag, which is why we continue to expect its more visible for commodity demand to become apparent in commodity prices later in 2H19 and next year. This lagged effect can be seen in our expectation for the evolution of EM import volumes to year end, which we estimate using data compiled the CPB World Trade Monitor (Chart 5). EM import volumes are closely tied to the evolution of EM income, which drives global commodity demand.8 Chart 4Globally, The Real Economy Has Slowed Chart 5EM Imports and Income Will Rebound In our modeling of supply-demand balances and prices, we accounted for the reduced EM GDP growth brought about by more restrictive monetary policy last year and the slowdown in global trade in our most recent forecast. In our base case, we took our expected global oil-demand growth this year down to 1.35mm b/d from 1.5mm b/d earlier, and to 1.55mm b/d next year from 1.6mm b/d previously. These adjustments reduced our price expectation for Brent crude oil slightly to $73/bbl this year and $75/bbl next year, with WTI trading $7/bbl and $5/bbl below those respective levels (Chart 6). Chart 6Our Forecasts Reflect Lower Demand, Tighter Supply Oil Markets Will Get Tighter   For all of the concern over real demand, prompt demand remains stout relative to available supply, as can be seen in the backwardations for global benchmark crude oil prices (Chart 7). This week’s extension of OPEC 2.0’s production cuts into 1Q20 means supply growth will remain constrained, which, given our demand expectation, will tighten balances globally (Chart 8).9 Chart 7Global Oil Benchmarks Remain Backwardated Chart 8Oil Supply Demand Balances Will TightenChart 9Oil Inventories Will Fall, As Supply Is Constrained As balances tighten in the wake of global fiscal and monetary stimulus, oil prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand (Chart 9). For this reason we remain long September – December 2019 Brent vs. short September – December 2020 Brent, expecting backwardation to increase.10 Bottom Line: We remain constructive toward oil markets, as they transition to a more accommodative monetary backdrop globally. Combined with fiscal stimulus in the U.S. and China in particular, demand will remain supported in 2H19 and 2020. The extension of OPEC 2.0’s production-cutting deal will tighten markets, forcing refiners to draw down inventories.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1      OPEC 2.0 is a name we coined for the OPEC/non-OPEC oil-producing coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Their agreement to extend production cuts of 1.2mm b/d into 1Q19 was announced this week in Vienna. Please see OPEC/non-OPEC rolls over oil output cuts for 9 months published by S&P Global Platts on July 2, 2019. Compliance with these cuts has been higher by ~ 400k b/d in 1H19 by our reckoning. 2      Please see Venezuela's June oil exports recover to over 1 million bpd: data published July 2, 2019, by reuters.com. 3      Please see Copper concs TCs drop marginally on traders purchase; Cobre Panama’s fresh supply hits market published by Fastmarkets MB June 28, 2019. 4      We are using “volatility” in the technical sense here – i.e., the standard deviation of per-annum returns. We have shown this can be explained by different variables, including EM volatility; U.S. financial conditions – as seen in the St. Louis Fed’s financial-stress index; and by speculative positioning, which tends to follow the evolution of prices as news flows change. For discussions of our volatility modeling, including the construction of Working’s T index, please see Specs Back Up The Truck For Oil, published April 26, 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility, published May 10, 2018, by BCA Research’s Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. 5      Please see The economic implications of rising protectionism: a euro area and global perspective published by European Central Bank April 24, 2019. 6      Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah, BCA Research’s global macro outlook for 3Q19, published June 28, 2019, by our Global Investment Strategy. It is available at gis.bcaresearch.com.  The larger issues that will have to be addressed at some point in the future are non-tariff barriers to trade, exemplified by Huawei’s exclusion from access to U.S. technology on national security grounds.  An expansion of such non-tariff barriers would strand huge amounts of capital globally, which likely would lead to a global recession. 7      Our chief global strategist, Peter Berezin, notes in the above-cited BCA Research third-quarter outlook that Fed policy is expected to remain ultra-accommodative into late 2021, which will push the USD lower later this year, and will support commodity demand generally. 8      We use an FX-based model to estimate EM import volumes to year end off the CPB data. 9      We will be updating our Venezuela and OPEC 2.0 production estimates to reflect this development in our July global oil market balance publication later this month. 10     We have been long 2H19 Brent vs. short 2H20 Brent since February 28, 2019.  The July and August pieces of this position returned 222.7% and 273% since inception. We remain long the September – December exposure. Investment Views and Themes Recommendations Strategic Recommendations TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights The EM equity and currency rebounds should be faded. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. This is the case in EM and China. Our leading indicators for the Chinese business cycle continue to point to intensifying profit contraction in both China and EM. The ratio of global broad money supply to the current value of securities worldwide is at an all-time low. This casts doubt on the “too much money chasing too few assets” hypothesis. Feature Chart I-1EM Share Prices: Decision Time EM share prices are at a critical juncture (Chart I-1). Their ability to hold their recent lows and break above their April highs will signify that a sustainable cyclical rally is in the making. Failure to punch through April’s highs will pose a major breakdown risk. In brief, EM is facing a make-it-or-break-it moment. Fundamentally, the outlook for EM risk assets and currencies largely hinges on economic growth in general and corporate profits in particular. In our June 20 report, we illustrated that the primary drivers of EM risk assets and currencies have historically been their business cycles and profit growth – not U.S. interest rates. Falling interest rates are positive for share prices when profits are expanding, even if at a slower rate. However, when corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Hence, lower global interest rates in of themselves are not a sufficient condition to foster a sustainable cyclical EM rally. As to EM corporate profits, the rate of their contraction will continue deepening. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. That is why BCA’s Emerging Markets Strategy team contends that EM risk assets and currencies, as well as China-plays, face the risk of a breakdown. This differs from BCA’s house view, which is positive on global risk assets in general. Global And Chinese Business Cycles: No Recovery So Far Chart I-2Chinese A-Share EPS Is Heading Into Contraction The rebound in EM risk assets and currencies since last December has occurred despite no improvement in both China’s business cycle and global trade, and despite the deepening contraction in EM corporate profits. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. So far, our baseline economic view has played out – mainland growth has been rather weak, and global trade has contracted. Yet EM financial markets have done better than we had anticipated. China’s domestic industrial new orders lead Chinese A-share earnings per share growth rate by about nine months and point to intensifying profit slump into early 2020 (Chart I-2). Furthermore, China’s adjusted narrow money(M1+)1 growth leads Chinese investable stocks earnings per share (EPS) by about nine months, and is also pointing to further compression (Chart I-3). Finally, Korea’s exports are shrinking, as are EM EPS (Chart I-4, top panel). Chart I-3Chinese Investable Companies' EPS Is Already Shrinking Chart I-4Korean Exports And EM EPS   Notably, both Korean exports values and EM EPS in U.S. dollars terms are on par with their early  2011 levels (Chart I-4, bottom panel). This indicates that neither Korean exports nor EM EPS have expanded sustainably over the past eight years. Chart I-5Global Stocks Did Not Lead Global PMI Historically Is it possible that the current gap between global share prices and global manufacturing is due to the fact that financial markets are forward-looking and lead business cycles? Historical evidence suggests that global share prices have not led the global manufacturing PMI, as exhibited in Chart I-5. In fact, global share prices have actually been coincident with the global manufacturing PMI not only throughout this decade but before that as well. The de-coupling between share prices and the manufacturing PMI is currently also present in EM, albeit in a less-striking form. Chart I-6 illustrates that the EM manufacturing PMI has slipped below 50 line, yet share prices have recently rebounded and sovereign spreads have tightened. In a nutshell, the divergence between global share prices and the global manufacturing PMI is unprecedented. This cannot be explained by falling global bond yields either. The latter were falling in the previous business cycle downtrends (2011-12 and 2015), yet share prices did not deviate from the global manufacturing PMI during those episodes (Chart I-5). Chart I-6EM PMI And EM Risk Assets Chart I-7The Rest Of World's Exports To China Will Continue Shrinking It seems that the global equity and credit markets expect an imminent recovery in the global business cycle in general and in China in particular. As we elaborated in the previous reports, the current global manufacturing recession stems primarily from China. Our leading indicators of the mainland business cycle suggest that more growth disappointments are likely before China’s growth and other economies’ shipments to the mainland hits a bottom (Chart I-7). For example, Korea’s exports to China in June were still dropping by 24% from a year ago. The primary reason for the lack of revival in growth is that China’s stimulus efforts have so far not been large enough, and the marginal propensity to spend among households and companies is diminishing, offsetting the positive effect of the stimulus, as we have discussed in previous reports. Will the recent G20 trade truce between the U.S. and China boost business confidence worldwide and in China? In our view, it is unlikely to produce a quick and meaningful recovery in business confidence among multinational companies and Chinese businesses. Corporate managers have probably come to realize that the U.S.-China row is not about import tariffs but rather geopolitical confrontation between the existing hegemon and a rising superpower. Hence, there is no easy solution that will satisfy both parties. An acceptable resolution for China will be unacceptable for the U.S., and vice versa. Hence, it will be hard to find a formula that gratifies both sides politically and economically. Overall, we reckon there are low odds in the next six months of an agreement between the U.S. and China that removes tariffs, addresses structural issues and satiates both nations. Korea’s exports are shrinking, as are EM EPS. Finally, even though the S&P 500 is hovering around its previous highs, under-the-surface dynamics have been less upbeat. Specifically, the equal-weighted share price index of U.S. high-beta stocks in cyclical sectors such as industrials, technology and consumer discretionary versus the S&P 500 has been tame and has not yet broken above its 200-day moving average (Chart I-8, top panel). The same holds true for the relative performance of an equal-weighted stock index of global cyclical sectors such as industrials, materials and semiconductors against the overall global equity benchmark (Chart I-8, bottom panel). Conversely, despite its recent setback, the U.S. dollar has technically not yet broken down (Chart I-9, top panel). In fact, our composite momentum indicator for the broad trade-weighted dollar has troughed at zero – a sign that downside is limited and another up-leg will likely emerge soon (Chart I-9, bottom panel). Chart I-8Cyclical Stocks Have Been Underperforming Chart I-9The U.S. Dollar Has Technically Not Broken Down   Bottom Line: The EM equity and currency rebounds should be faded. As EM currencies depreciate, sovereign and corporate credit spreads will likely widen. Asset allocators should continue underweighting EM equities and credit markets relative to their DM peers. Too Much Money Chasing Too Few Assets? Many investors identify “liquidity” as the main reason why global equity and credit markets have done so well this year, despite the relapsing global business cycle. Yet there are as many definitions of “liquidity” as there are investors. Many commentators use the term “liquidity” to denote balance sheet expansion by global central banks. As part of their quantitative easing programs, central banks in the U.S., U.K., Japan, the euro area, Switzerland and Sweden have expanded their balance sheets enormously. In line with their asset expansion, their liabilities – the monetary base, consisting primarily of commercial banks’ excess reserves – have also mushroomed. Nevertheless, broad money supply has grown only modestly in these economies.2 The principal reason behind this phenomenon has been a collapse in the money multiplier due to both banks’ unwillingness to boost lending proportionally to their swelling excess reserves, and a persistent lack of demand for credit among households and businesses. This computation casts doubt on the “too much money chasing too few assets” hypothesis. Broad money supply includes all types of deposits at commercial banks and cash in circulation. Crucially, it does not include commercial banks’ excess reserves at central banks. This differentiation between broad money and excess reserves at central banks is vital because excess reserves are not used to purchase goods, services or assets/securities. Hence, a true measure of purchasing power for assets, goods and services is broad money supply. Consistently, the pertinent liquidity ratio for financial markets can be computed by dividing global broad money supply by the value of all securities outstanding excluding those owned by central banks. The top panel of Chart I-10 depicts the ratio of the sum of broad money supply in 12 economies3 - excluding China - to the market value of investable global equities and bonds. The latter is calculated as the market cap of the Datastream World Equity Index plus the market value of the Barclays Aggregate Bond Index, excluding securities owned by central banks (Chart I-11). Bonds include both government and corporate issues. Chart I-10Comparing Global Broad Money And Market Value Of Outstanding Securities Chart I-11Broad Money, Securities Absorbed By QEs And Value Of Outstanding Securities   We exclude China from this calculation because its money supply (deposits) is not internationally “mobile” – i.e., due to capital controls, Chinese residents cannot convert their renminbi deposits to other currencies, or use them to purchase international securities. Likewise, we exclude Chinese on-shore equity and bond markets from the calculation because they are not easily accessible to all foreign investors. This broad money supply-to-asset values ratio can be regarded as a rough proxy for available liquidity for financial markets.4 Our interpretation is that a lower ratio means investors have lower cash balances relative to the value of financial assets they hold, and vice versa. Interestingly, the ratio of global broad money to the current value of securities worldwide is at an all-time low (Chart I-10, top panel). Hence, this computation casts doubt on the “too much money chasing too few assets” hypothesis. By flipping this ratio, we compute the ratio of market value of all investable securities (excluding the ones owned by central banks) to broad money supply (Chart I-10, bottom panel). It is at all-time high entailing that the market value of globally investable publically-traded securities has expanded much more than global broad money supply/deposits. Bottom Line: We recognize that this is a simplistic macro exercise, and a more comprehensive methodology is required to compute global cash balances that are available to purchase securities worldwide. However, at minimum the above casts doubt on the hypothesis that “too much money is chasing too few assets”. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      M1+ is calculated as M1 plus household demand deposits and deposits at third-party payment platforms. 2      Note that when a central bank purchases securities from commercial banks, this operation originates excess reserves, but not a new deposit at commercial banks. However, when a central bank acquires securities from a non-bank entity, such as a pension fund or an insurance company, this transaction creates both excess reserves and a bank deposit that did not exist before. Hence, QE programs have created some deposits but less so than excess reserves. 3      Economies included into this aggregate are the U.S., the euro area, the UK, Japan, Canada, Australia, Switzerland, Sweden, Korea, Taiwan, Hong Kong and Singapore. 4      This calculation does not strip out transactional demand for money, i.e., how much money is required to finance regular  economic activity. Given transactional demand for money is not stable, it is hard to estimate and adjust for it.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Current activity indicators are now losing momentum, or outright rolling over. This confirms that European (and global) growth is now entering a down-oscillation. Why? It is the rate of decline in the bond yield that has driven the current up-oscillation in growth and it is mathematically impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Equity investors should rotate from pro-cyclical to pro-defensive sectors. But the support to risk-asset valuations from low bond yields will keep the aggregate European equity market in a sideways channel. Feature Chart of the WeekThe Interest Rate Impulse And Credit Impulse Are Both Entering ##br##Down-Oscillations If the level of interest rates drove economic growth then, let’s face it, the economies of Japan and Switzerland would have reached the moon by now! In both Japan and Switzerland, the policy rate and long bond yield have been at ultra-low levels for decades (Chart I-2). This is true for both the nominal level and the real level of the interest rate and bond yield. But we all know that the level of interest rates does not drive economic growth. Chart I-2Japan And Switzerland Have Had Ultra-Low Bond Yields For Decades If Interest Rates Decline At A Reduced Pace, Growth Slows Most people understand that it is the change in interest rates that can drive economic growth. The main transmission mechanism is by adding to or subtracting from credit creation. For example if, in a given period, a -0.5 percent decline in the interest rate added €50 billion to credit creation, then the extra €50 billion would constitute additional economic demand. Many people struggle to understand the subtle and counterintuitive follow-on point. If interest rates decline, but at a reduced pace, it can slow economic growth. To understand why, let’s continue the example. If, in the following period, a further -0.5 percent decline in the interest rate added another €50 billion of credit-sourced demand, it would constitute the same rate of growth as in the first period. But a further -0.25 percent decline in the interest rate which added €25 billion to demand would result in the growth rate halving. The counterintuitive thing is that the interest rate has continued to decline, yet it has caused growth to slow! If interest rates decline, but at a reduced pace, it can slow economic growth. This counterintuitive dynamic is about to unfold in the European and global economy during the second half of this year. The pace of change in the interest rate (inverted) drives the credit impulse, and thereby drives short-term growth oscillations (Chart I-3). Of course, other influences on credit creation can sometimes swamp the interest rate impact. But not in the latest cycle. From the fourth quarter of 2018, both the pace of decline in the interest rate – or more precisely, the bond yield – and the credit impulse were in a synchronised and closely connected up-oscillation. Chart I-3The Pace Of Change In the Bond Yield (Inverted) Drives The Credit Impulse Unfortunately, it is mathematically impossible for the pace of decline in the bond yield to keep increasing, or indeed stay where it is. Hence, both the interest rate and credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year (Chart of the Week). Growth Rebounded, But Will Now Fade From the fourth quarter of 2018, European and global growth very clearly entered an up-oscillation. Let’s list all the evidence: First and foremost, quarter-on-quarter GDP growth rates picked up: by 2.5 percent in Germany; by 1 percent in the euro area; and by 1 percent in the developed economies (Chart I-4).1 The stark evidence that growth rebounded, but is now rolling over. The best current activity indicators rebounded: specifically the ZEW economic sentiment indicators for both Germany and the euro area (Chart I-5 and Chart I-6); the euro area composite PMI picked up too, albeit very modestly. Chart I-4Global Growth Rebounded... But Is Now Likely To Roll Over Chart I-5Current Activity Indicators ##br##Rebounded... Chart I-6...But Are Now Rolling Over The aforementioned interest rate impulses (inverted) and 6-month credit impulses picked up, and sharply in China (Chart I-7). Chart I-7Short-Term Impulses Rebounded... But Are Now Rolling Over The equity sector that is most exposed to growth – the industrials – strongly outperformed the broader market, especially in the euro area (Chart I-8). Chart I-8Industrials Outperformed Strongly... But Are Now Rolling Over In fact, just the first item on our list, the pick-up in GDP growth, should suffice to demonstrate the up-oscillation in growth, and that should be that. After all, GDP – after revisions – is the broadest measure of economic activity. Nevertheless, for the sceptics, the corroboration of four independent pieces of evidence should, once and for all, confirm that growth rebounded late last year and early this year. Now though, all of these indicators are losing momentum, or outright rolling over. This confirms that growth is now entering a down-oscillation. Why? To repeat, it is the rate of decline in the bond yield that has driven the current up-oscillation in growth and it is mathematically impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. The ultimate test of a good theory is its predictive power. In the case of investment strategy this means calling the markets right. Our bond yield and credit impulse oscillation framework passes this test with flying colours, especially at the last two turning-points. On February 1, 2018 at the onset of the last down-oscillation we correctly recommended: “Downgrade banks to underweight versus healthcare” Then on August 30 2018 at the onset of the last up-oscillation we correctly recommended:  “Take profits in the 35 percent outperformance of European healthcare versus banks” Now, at the onset of a new down-oscillation, we recommended last week that equity investors should as a first step go underweight European industrials and switch once again to the less economically-sensitive and less price-sensitive healthcare sector. Sector rotation has huge implications for equity market regional and country allocation. Nowadays, regional and country relative performance just comes from the dominant stock and sector fingerprints of each stock market. Next week, we will advise on what the onset of a new down-oscillation means for Europe as a region relative to the world as well as for equity market allocation within Europe. Enhancing The ‘Rule Of 4’ And The ‘Rule Of 3’ The level of interest rates does not drive economic growth, but the level of interest rates – or more precisely, bond yields – does drive the valuations of equities and other risk-assets. Moreover, it does so in a viciously non-linear way. Essentially, at a tipping point, higher bond yields can suddenly undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse on the economy. How can we sense this tipping point? Previously we defined it as when the sum of the 10-year yields on the T-bond, German bund, and JGB is at 4 percent, the ‘rule of 4’. Conversely, when the sum is below 3 percent, the ‘rule of 3’, the seemingly rich valuation of equities and other risk-assets is well underpinned.2 Higher bond yields can suddenly undermine the valuation support of equities. Did this framework work? Yes, perfectly. On September 13 2018 when the global bond yield was approaching danger level, our framework was spot-on in forecasting that: “Using the 10-year T-bond yield as a roadmap, a short trip to the uplands of 3.5 percent would precede a longer journey down to 2 percent” Nevertheless, today we are enhancing the rule. The global bond yield must include China and it must include the aggregate euro area rather than just Germany. Hence, our enhanced metric is the simple average of the 10-year yields of the U.S., the euro area, and China. But to simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China (Chart I-9). Chart I-9The Rules Of 4 And 3 Become The Rules Of 2.5 And 2 A value approaching 2.5 equates to danger for equities and risk-assets. A value below 2.0 equates to an underpinning for equities and risk-assets. Today, the value stands at 1.8. So to sum up, European (and global) growth will experience a down-oscillation in the second half of 2019, but the support to risk-asset valuations will keep the aggregate European equity market in a sideways channel. For equity investors, the big game in town will be sector rotation, as well as regional and country rotation. Of which, more next week. Stay tuned. Fractal Trading System*  This week we note that the spectacular rally in the Greek stock market this year is now ripe for a countertrend move. We prefer to play this on a hedged basis, so this week’s recommended trade is short Athex versus the Eurostoxx 600. Set the profit target at 7 percent with a symmetrical stop-loss. Chart I-10 The Fractal Trading System now has five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on a GDP weighted average of the U.S., euro area, and Japan. 2 Please see the European Investment Strategy Weekly Report ‘The Rule Of 4 Becomes The Rule Of 3’ dated March 21, 2019 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 28, 2019.  The quant model has upgraded Sweden to the second largest overweight (from a slight underweight) mainly due to sharp improvement in the liquidity indicator. This is financed by reductions in the overweight of Germany, Italy and the downgrade of Switzerland to a slight underweight (from overweight), as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI world benchmark by 39 bps in June, largely driven by 104 bps of outperformance from Level 2 model, offset by 10 bps of underperformance from Level 1.  Directionally, six out of the 12 choices generated positive alpha. The largest contributions to the outperformance in June came from the overweight in Italy and the underweight in Japan.  Since going live, the overall model has outperformed by 238 bps, with 511 bps of outperformance by the Level 2 model, offset by 2 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of June 28, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model increased its cyclical exposure by overweighting Materials on the backdrop of improvement in its momentum component. The model is therefore overweight two cyclical and two defensive sectors – Industrials, Materials, Consumer Staples and Utilities. The valuation component remains muted across all sectors. The growth component continues to favor defensive sectors so far, as an improvement in global growth hard data has not yet materialized. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com    

Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession?   Recommendations Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up   Chart 5No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 16Downgrade Japan To Underweight   It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy?   For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com   GAA Asset Allocation

Highlights Fed policy is likely to proceed in two stages: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage, which will end in late 2021, will be heaven for risk assets. The subsequent stage, which will feature a global recession, will be hell. In the end, we expect the fed funds rate to reach 4.75%, representing thirteen more 25-basis point hikes than implied by current market pricing. For the time being, investors should maintain a pro-risk stance: Overweight global equities and high-yield credit relative to government bonds and cash. Regardless of what happens to the trade negotiations, China is stimulating its economy, which will benefit global growth. As a countercyclical currency, the dollar will weaken over the next 12 months. Cyclical stocks will outperform defensives. We expect to upgrade European and EM stocks this summer. Feature Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, July 3rd at 10:00 AM EDT, where I will be discussing the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist Macro Outlook Right On Stocks, Wrong On Bonds We turned structurally bullish on global equities following December’s sell-off, having temporarily moved to the sidelines last June. This view has generally played out well. In contrast, our view that bond yields would rise this year as stocks recovered has been one gigantic flop. What went wrong with the bond view? The answer is that central banks are reacting to incoming news and data differently than in the past. As we discuss below, this has monumental implications for investment strategy. A Not So Recessionary Environment If one had been told at the start of the year that investors would be expecting the fed funds rate to fall to 1.5% by mid-2020 – with a 93% chance that the Fed would cut rates at least twice and a 62% chance it will cut rates three times in 2019 – one would probably have assumed that the U.S. had teetered into recession and that the stock market would be down on the year (Chart 1). Instead, the S&P 500 is near an all-time high, while credit spreads have narrowed by 145 bps since the start of the year. Outside the manufacturing sector, the economy continues to grow at an above-trend pace and the unemployment rate is below most estimates of full employment. According to the Atlanta Fed, real final domestic demand is set to increase by 2.8% in Q2, up from 1.6% in Q1. Real personal consumption expenditures are tracking to rise at a 3.7% annualized pace (Chart 2). So why is the Fed telegraphing rate cuts when real interest rates are barely above zero? A few reasons stand out: Global growth has slowed (Chart 3). The trade war has heated up again following President Trump’s decision to further increase tariffs on Chinese goods. Inflation expectations have fallen in the U.S. as well as around the world (Chart 4). Chart 3Global Growth Has Slowed Chart 4Inflation Expectations Have Fallen Around The World   There’s More To The Story As important as they are, these three factors, even taken together, would not be enough to justify rate cuts were it not for an additional consideration: The Fed, like most other major central banks, has become increasingly worried that the neutral rate of interest – the rate consistent with full employment and stable inflation – is extremely low. This has resulted in a major shift in its reaction function. Nobody really knows exactly where the neutral rate is. According to the widely-cited Laubach Williams (L-W) model, the nominal neutral rate stands at 2.2% in the United States. This is close to current policy rates (Chart 5). The range for the longer-term interest rate dot in the Summary of Economic Projections is between 2.4% and 3.3%, which is higher than the L-W estimate. However, the range has trended lower since it was introduced in 2014 (Chart 6). Chart 5The Fed Thinks Rates Are Close To Neutral A Fundamental Asymmetry Given that inflation expectations are quite low and there is considerable uncertainty over the level of the neutral rate, it does make some sense for policymakers to err on the side of being too dovish rather than too hawkish. This is because there is an asymmetry in monetary policy in the current environment. If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always raise rates. In contrast, if the neutral rate turns out to be very low, the decision to hike rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by over five percentage points during recessions (Chart 7). At the present rate of inflation, the zero-lower bound on interest rates would be quickly reached, at which point monetary policy would become largely impotent. Chart 7The Fed Is Worried About The Zero Bound The asymmetry described above argues in favor of letting the economy run hot in order to allow inflation to rise. A higher inflation rate going into a recession would let a central bank push real rates deeper into negative territory before the zero bound is reached. In addition, a higher inflation rate would facilitate wage adjustments in response to economic shocks. Firms typically try to reduce costs when demand for their products and services declines, but employers are often wary of cutting nominal wages. Even though it is not fully rational, workers get more upset when they are told that their wages will fall by 2% when inflation is 1% than when they are told their wages will rise by 1% when inflation is 3%. More controversially, a modestly higher inflation rate could improve financial stability. In a low-inflation, low-nominal-rate environment, risky borrowers are likely to be able to roll over loans for an extended period of time. This could lead to the proliferation of bad debt. Chart 8Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher inflation can also cushion the blow from a burst asset bubble. For example, the Case-Shiller 20-City Composite Index fell by 34% between 2006 and 2012, or 41% in real terms. If inflation had averaged 4% over this period and real home prices had fallen by the same amount, nominal home prices would have declined by only 26%, resulting in fewer underwater mortgages (Chart 8). A New Reaction Function It is usually a mistake to base market views on an opinion about what policymakers should do rather than what they will do. On rare occasions, however, the opposite is true. And, where our Fed call is concerned, this seems to be the case. Where we fumbled earlier this year was in assuming the Fed would follow a more traditional, Taylor Rule-based monetary framework, which calls for raising rates as the output gap shrinks. Instead, the Fed has adopted a risk-based approach of the sort described above, reminiscent in many ways of the optimal control framework that Janet Yellen set out in 2012. The New Normal Becomes The New Consensus If one is going to conduct monetary policy in a way that errs on the side of letting the economy overheat, one should not be too surprised if the economy does overheat. Yet, the implied rate path from the futures curve suggests that investors are not taking this risk seriously. Chart 9 shows that investors are assigning a mere 5% chance that U.S. short-term rates will be above 3.5% in mid-2022. Why isn’t the market assigning more of a risk to an inflation overshoot? We suspect that most investors have bought into the consensus view that the real neutral rate is zero. According to this view, U.S. monetary policy had already turned restrictive last year when the 10-year Treasury yield climbed above 3%. If this view is correct, the recent decline in yields may stave off a recession, but it will not be enough to cause the economy to overheat. Many of the same investors also believe that deep-seated structural forces ranging from globalization, automation, demographics, to the waning power of trade unions, will all prevent inflation from rising much over the coming years even if the unemployment rate continues to fall. In other words, the Phillips curve is broken and destined to stay that way. But are these views correct? We think not.  Where Is Neutral? There is a big difference between arguing that the neutral rate may be low – and taking preemptive steps to remedy it – and arguing that it definitely is low. We subscribe to the former view, but not the latter. Our guess is that in the end, we will discover that the neutral rate is lower than in the past, but not nearly as low as investors currently think. Probably closer to 1.5% in real terms than 0%. As we discussed in detail two weeks ago, while a deceleration in trend growth has pushed down the neutral rate, other forces have pushed it up.1 These include looser fiscal policy (especially in the U.S.), a modest revival in private-sector credit demand, and dwindling labor market slack.  Since the neutral rate cannot be observed directly, the best we can do is monitor the more interest rate-sensitive sectors of the economy to see if they are cooling in a way that would be expected if monetary policy had become restrictive. For example, housing is a long-lived asset that is usually financed through debt. Hence, it is highly sensitive to changes in mortgage rates. History suggests that the recent decline in mortgage rates will spur a rebound in home sales and construction later this year (Chart 10). The fact that homebuilder confidence has bounced back this year and purchase mortgage applications have reached a cycle high is encouraging in that regard. The same goes for the fact that the vacancy rate is near an all-time low, housing starts have been running well below the rate of household formation, and the quality of mortgage lending has been quite strong (Chart 11). Chart 10Declining Yields Bode Well For Housing Chart 11U.S. Housing: No Oversupply Problem, While Demand Is Firm     Nevertheless, if the rebound in housing activity fails to materialize, it would provide evidence that other factors, such as job security concerns among potential homebuyers, are overwhelming the palliative effects of lower mortgage rates.  Have Financial Markets “Trapped” Central Banks? An often-heard argument is that central banks can ill-afford to raise rates for fear of unsettling financial markets. Proponents of this argument often mention that the value of all equities, corporate bonds, real estate and other risk assets around the world exceeds $400 trillion, five times greater than global GDP. There are at least two things wrong with this argument. First, an increase in financial wealth should translate into more spending, and hence a higher neutral rate of interest. Second, as we discussed earlier this year, the feedback loop between asset prices and economic activity tends to kick in only when monetary policy has already become restrictive.2  When policy rates are close to or above neutral, further rate hikes threaten to push the economy into recession. Corporate profits inevitably contract during recessions, which hurts risk asset prices. A vicious spiral can develop where falling asset prices lead to less spending throughout the economy, leading to lower profits and even weaker asset prices. In contrast, when interest rates are below their neutral level, as we believe is the case today in the major economies, an increase in policy rates will simply reduce the odds that the economy will overheat, which is ultimately a desirable outcome. U.S. Imbalances Are Modest Chart 12U.S. Corporate Debt (I): No Cause For Alarm Recessions usually occur when rising rates expose some serious imbalances in the economy. In the U.S. at least, the imbalances are fairly modest. As noted above, housing is on solid ground, which means that mortgage rates would need to rise substantially before the sector crumbles. Equities are pricey, but far from bubble territory. Moreover, unlike in the late 1990s, the run-up in stock prices over the past five years has not led to a massive capex overhang. Corporate debt is the weakest link in the financial system, but we should keep things in perspective. Even after the recent run-up, net corporate debt is only modestly higher than it was in the late 1980s, a period where the fed funds rate averaged nearly 10% (Chart 12). Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above its long-term average, while the ratio of debt-to-assets is below its long-term average (Chart 13). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Every recession during the past 50 years has begun when the corporate sector financial balance was in deficit (Chart 14). Chart 13U.S. Corporate Debt (II): No Cause For Alarm Chart 14U.S. Corporate Debt (III): No Cause For Alarm     The Dollar, The Neutral Rate, and Global Growth In a globalized economy, capital flows can equalize, at least partially, neutral rates across countries. If any one central bank tries to raise rates – while others are standing pat or even cutting rates – the currency of the economy where rates are rising will shoot up, causing net exports to shrink and growth to slow.  In the case of the U.S. dollar, there is an additional issue to worry about, which is that there is about $12 trillion in overseas dollar-denominated debt. A stronger greenback would make it difficult for external borrowers to service their debts, leading to increased bankruptcies and defaults. Since financial and economic imbalances are arguably larger outside the U.S., a rising dollar would probably pose more of a problem for the rest of the world than for the United States. Although this is a serious risk, it is unlikely to materialize over the next 12-to-18 months, given our assumption that the dollar will weaken over this period. The U.S. dollar trades as a countercyclical currency, which is another way of saying that it tends to weaken whenever global growth strengthens (Chart 15). While the U.S. benefits from faster global growth, the rest of the world benefits even more. This stems from the fact that the U.S. has a smaller manufacturing base and a larger service sector than most other economies, which makes the U.S. a “low beta” economy. Hence, stronger global growth tends to cause capital to flow from the U.S. to the rest of the world, putting downward pressure on the greenback. Right now, China is stimulating its economy. The stimulus is a reaction to both slowing domestic growth, as well as worries about the potential repercussions of a trade war. It also reflects the fact that Chinese credit growth had sunk to a level only modestly above nominal GDP growth late last year. With the ratio of credit-to-GDP no longer rising quickly, the authorities had the luxury of suspending the deleveraging campaign (Chart 16). Chart 15The Dollar Is A Countercyclical Currency Chart 16Chinese Deleveraging Campaign Has Now Been Put On The Backburner   The combination of Chinese stimulus, the lagged effects from lower bond yields, and a turn in the global manufacturing cycle should all lift global growth in the back half of this year. This should cause the dollar to weaken. Trade War Worries Needless to say, this rosy outlook is predicated on the assumption that the trade war does not get out of hand. Our baseline envisions a “muddle through” scenario, where some sort of deal is hatched that allows the U.S. to bring down existing tariffs over time in exchange for a binding agreement by the Chinese to improve market access for U.S. companies and better secure intellectual property rights. The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a “small” trade war and a “moderate” trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system. What is less familiar, and much more dangerous to global finance, are nontariff barriers that effectively bar countries from accessing critical inputs and technologies. Most global trade is in the form of intermediate goods (Chart 17). If a company cannot access the global supply chain, there is a good chance it may not be able to function at all. The current travails of Huawei is a perfect example of this. A full-blown trade war would create a lot of stranded capital. The stock market represents a claim on the existing capital stock, not the capital stock that would emerge after a trade war has been fought. Stocks would plunge in this scenario, with the U.S. and most other economies succumbing to a recession. Enough voters would blame Donald Trump that he would lose the election. While such an outcome cannot be entirely dismissed, it is precisely its severity that makes it highly unlikely. Inflation: Waiting For Godot? Global monetary policy is highly accommodative at present, and will only become more so if the Fed and some other central banks cut rates. Provided that the trade war does not boil over, global growth should accelerate, putting downward pressure on the U.S. dollar. A weaker dollar will further ease global financial conditions. In such a setting, global growth is likely to remain above trend, leading to a further erosion of labor market slack. Among the major economies, the U.S. is the closest to exhausting all remaining spare capacity (Chart 18). The unemployment rate has fallen to 3.6%, the lowest level since 1969. The number of people outside the labor force who want a job as a share of the working-age population is below the level last seen in 2000. The quits and job opening rates remain near record highs. Given the erosion in slack, why has inflation not taken off? To some extent, the answer is that the Phillips curve is “kinked.” A decline in the unemployment rate from say, 8% to 5%, does little to boost inflation because even at 5%, there are enough jobless workers keen to accept what employment offers they get. It is only once the unemployment rate falls well below NAIRU that inflation starts to kick in. In the 1960s, it was not before the unemployment rate fell two percentage points below NAIRU that inflation broke out (Chart 19). Chart 18U.S. Is Back To Full Employment Chart 19Inflation Took Off In The 1960s Amid An Overheated Economy   Wage growth has picked up. However, productivity growth has risen as well. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 20).  Chart 20No Imminent Threat Of A Wage-Price Inflationary Spiral As the unemployment rate continues to drop, wage growth is likely to begin outstripping productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue thereafter. Could structural forces related to globalization, automation, demographics, and waning union power prevent inflation from rising even if labor markets tighten significantly further? We think that is unlikely. Globalization Regardless of what happens to the trade war, the period of hyperglobalization, ushered in by the fall of the Berlin Wall and China’s entry into the WTO, is over. As a share of global GDP, trade has been flat for more than ten years (Chart 21).  Chart 21Globalization Has Peaked Granted, it is not just the change in globalization that matters for inflation. The level matters too. In a highly globalized world, excess demand in one economy can be satiated with increased imports from another economy. However, this is only true if other economies have enough spare capacity. Even outside the United States, the unemployment rate in the G7 economies is approaching a record low (Chart 22). Chart 22The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows In any case, for a fairly closed economy such as the U.S., where imports account for only 15% of GDP, relative prices would need to shift a lot in order to incentivize households and firms to purchase substantially more goods from abroad. In the absence of dollar appreciation, this would require that the prices of U.S. goods increase in relation to the prices of foreign goods. In other words, U.S. inflation would still have to rise above that of the rest of the world. Automation Everyone likes to think that they are living in a special age of technological innovation. Yet, according to the productivity statistics, U.S. productivity has grown at a slower pace over the last decade than during the 1970s (Chart 23). As we argued in a past report, this is unlikely to be the result of measurement error.3  Perhaps the recent pickup in productivity growth will mark the start of a new structural trend. Maybe, but it could also just reflect a temporary cyclical revival. As labor has become less plentiful, companies have started to invest in more capital. Chart 24 shows that productivity growth and capital spending are highly correlated over the business cycle. Chart 24U.S. Productivity Growth And Capex Move In Lock-Step   It is less clear whether total factor productivity (TFP) growth — which reflects such things as technological know-how and business practices – has turned the corner. Over the past two centuries, TFP growth has accounted for over two-thirds of overall productivity growth. Recent data suggests TFP growth in the U.S. and around the world has remained sluggish (Chart 25). Chart 25ATotal Factor Productivity Remains Muted Across Developed Markets Chart 25BTotal Factor Productivity Remains Muted Across Developed Markets     Even if TFP growth does accelerate, it is not obvious that this will end up being deflationary. Increased productivity means more income, but more income means more potential spending. To the extent that stronger productivity growth expands aggregate supply, it also has the potential to raise aggregate demand. Thus, while faster productivity growth in one sector will cause relative prices in that sector to fall, this will not necessarily reduce the overall price level. Chart 26Rising Labor Share Of Income Occurring Alongside Labor Market Tightening True, faster productivity growth has the ability to shift income from poor workers to rich capitalists. Since the former spend more of their income than the latter, this could slow aggregate demand growth. However, the recent trend has been in the other direction, as a tighter labor market has pushed up labor’s share of income (Chart 26). Among workers, wage growth is now higher at the bottom end of the income distribution than at the top (Chart 27). Demographics For several decades, slower population growth has reduced the incentive for firms to expand capacity. Population aging has also shifted more people into their prime saving years. The combination of lower investment demand and higher desired savings pushed down the neutral rate on interest. Chart 28The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, they are moving from being savers to dissavers. Chart 28 shows that ratio of workers-to-consumers globally has begun to decline as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The Waning Power Of Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 29). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 30). Chart 29Inflation Fell In Canada, Despite A High Unionization Rate Chart 30Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around   Ultimately, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Unions have influence over wages, but in the long run, central banks play the decisive role. Alt-Right Or Ctrl-Left, The Result Is Usually Inflation In a speech to the Council on Foreign Relations this week, Jay Powell noted that “The Fed is insulated from short-term political pressures – what is often referred to as our ‘independence’.”4 The operative words in his remarks were “short-term”. Powell knows full well that the Fed’s independence is not cast in stone. Even if Trump cannot legally fire or demote him, the President can choose who to nominate to the Fed’s Board of Governors. Early on in his tenure, Trump showed little interest in the workings of the Federal Reserve. He even went so far as to nominate Marvin Goodfriend – definitely no good friend of easy money – to the Fed board. Trump’s last two candidates, Stephen Moore and Herman Cain, were both political flunkies, happy to ditch their previous commitments to hard money in favor of Trump’s desire to see lower interest rates. Neither made it as far as the Senate confirmation process. Recent media reports have suggested that Trump will nominate Judy Shelton, a previously unknown economist whose main claim to fame is the promulgation of a bizarre theory about why the Fed should not pay interest on excess reserves (which, conveniently, would imply that overnight rates would need to fall to zero immediately).5  It is not clear whether Trump’s attempt to stack the Fed with lackeys will succeed. But one thing is clear: Countries with independent central banks tend to end up with lower inflation rates than countries where central banks are not independent (Chart 31). Whether it be Trump-style right-wing populism or left-wing populism (don’t forget, MMT is a product of the left, not the right), the result is usually the same: higher inflation. Investment Recommendations Overall Strategy The discussion above suggests the Fed will proceed along a two-stage path: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage will be heaven for risk assets. The subsequent stage will be hell. The big question is when the transition from stage one to stage two will occur. Inflation is a highly lagging indicator. It usually does not peak until a recession has begun and does not bottom until a recovery is well under way (Chart 32). While some measures of U.S. core inflation such as the Dallas Fed’s “trimmed mean” have moved back up to 2%, this follows a prolonged period of sub-target inflation. For now, the Fed wants both actual inflation and inflation expectations to increase. Thus, we doubt that inflation will move above the Fed’s comfort zone before 2021, and it will probably not be until 2022 that monetary policy turns contractionary. It will take even longer for inflation to rise meaningfully in the euro area and Japan. Recessions rarely happen if monetary policy is expansionary. Sustained equity bear markets in stocks, in turn, almost never happen outside of recessionary periods (Chart 33). As such, a pro-risk asset allocation, favoring global equities and high-yield credit over safe government bonds and cash, is warranted at least for the next 12 months. Chart 33Recessions And Equity Bear Markets Usually Overlap The key market forecast charts on the first page of this report graphically lay out our baseline forecasts for equities, bonds, currencies, and commodities. Broadly speaking, we expect a risk-on environment to prevail until the end of 2021, followed by a major sell-off in equities and credit. Equities Stocks tend to peak about six months before the onset of a recession. In the 13-to-24 month period prior to the recession, returns tend to be substantially higher than during the rest of the expansion (Table 1). We are approaching that party phase. Table 1Too Soon To Get Out Global equities currently trade at 15-times forward earnings. Unlike last year, earning growth estimates are reasonably conservative (Chart 34). Chart 34Global Stocks Are Not That Expensive Outside the U.S., stocks trade at a respectable 13-times forward earnings. Considering that bond yields are negative in real terms in most economies – and negative in nominal terms in Japan and many parts of Europe – this implies a sizable equity risk premium.  We have yet to upgrade EM and European stocks to overweight, but expect to do so some time this summer, once we see some evidence that global growth is accelerating. International stocks should do especially well in common-currency terms over the next 12 months, if the dollar continues to trend lower, as we expect will be the case.  We are less enthusiastic about Japanese equities. First, there is still the risk that the Japanese government will needlessly raise the consumption tax in October. Second, as a risk-off currency, the yen is likely to struggle in an environment of strengthening global growth. Investors looking for exposure to Japanese stocks should favor the larger multinational exporters. At the global sector level, cyclicals should outperform defensives in an environment of stronger global growth, a weaker dollar, and ongoing Chinese stimulus. We particularly like industrials and energy. Financials should catch a bid in the second half of this year. According to the forwards, the U.S. yield curve will steepen by 38 bps over the next six months (Chart 35). Worries about an inverted yield curve will taper off. Curves will also likely steepen outside the U.S. as growth prospects improve. A steeper yield curve is manna from heaven for banks. Euro area banks trade at an average dividend yield of 6.4% (Chart 36). We are buying them as part of a tactical trade recommendation. Chart 36Euro Area Banks Are A Buy     Fixed Income The path to higher rates is lined with lower rates. The longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. The Fed’s dovish turn means that rates will stay lower for longer, but will ultimately go higher than we had originally envisioned. As a result, we are increasing our estimate of the terminal fed funds rate for this cycle by 50 bps to 4.75% and initiating a new trade going short the March 2022 Eurodollar futures contract. Our terminal fed funds rate projection assumes a neutral real rate of 1.5% and a peak inflation rate of 2.75%. Rates will rise roughly 50 basis points above neutral in the first half of 2022, enough to generate a recession later that year. The 10-year Treasury yield will peak at 4% this cycle. While the bulk of the increase will happen in 2021/22, yields will still rise over the next 12 months, as U.S. growth surprises on the upside. Thus, a short duration stance is warranted even in the near-to-medium term. The German 10-year yield will peak at 1.5% in 2022. We expect the U.S.-German spread to narrow modestly through to end-2021 and then widen somewhat as U.S. inflation accelerates relative to German inflation. The spread between Italian and German yields will decline in the lead-up to the global recession in 2022 and widen thereafter. U.K. gilt yields are likely to track global bond yields, although Brexit remains a source of downside risk for yields. Our base case is either no Brexit or a very soft Brexit, given that popular opinion has turned away from leaving the EU (Chart 37). Chart 37U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Chart 38U.S. Default Losses Will Remain In Check   We expect only a very modest increase in Japanese yields over the next five years. Japanese long-term inflation expectations are much lower than in the other major economies, which will require an extended period of near-zero rates to rectify. We expect corporate credit to outperform government bonds over the next 12 months. While spreads are not likely to narrow much from present levels, the current yield pickup is high enough to compensate for expected bankruptcy risk. Our U.S. fixed-income strategists expect default losses on the Bloomberg Barclays High-Yield index on the order of 1.25%-1.5% over the next 12 months (Chart 38). In that scenario, the junk index offers 224 bps – 249 bps of excess spread, a solid positive return that is only slightly below the historical average of 250 bps.  Currencies And Commodities The two-stage Fed cycle described above will govern the trajectory of the dollar over the next few years. In the initial stage, where global growth is accelerating and the Fed is falling ever further behind the curve in normalizing monetary policy, the dollar will depreciate. Dollar weakness will be especially pronounced against the euro and EM currencies. Commodities and commodity currencies will see solid gains. Our commodity strategists are particularly bullish on oil, as they expect crude prices to benefit from both stronger global demand and increasingly tight supply conditions. The Chinese yuan will start strengthening again if a detente is reached in the trade talks. Even if a truce fails to materialize, the Chinese authorities will likely step up the pace of credit stimulus, rather than trying to engineer a significant, and possibly disorderly, devaluation.   In the second stage, where the Fed is desperately hiking rates to prevent inflation expectations from becoming unmoored, the dollar will soar. The combination of higher U.S. rates and a stronger dollar will cause global equities to crash and credit spreads to widen. The resulting tightening in financial conditions will lead to slower global growth, which will further turbocharge the dollar. Only once the Fed starts cutting rates again in late 2022 will the dollar weaken anew. Gold should do well in the first stage of the Fed cycle and at least part of the second stage. In the first stage, gold will benefit from a weaker dollar. In the initial part of the second stage, gold prices will continue to rise as inflation fears escalate. Gold will probably weaken temporarily once real interest rates reach restrictive territory and a recession becomes all but inevitable. We recommended buying gold on April 17, 2019. The trade is up 10.8% since then. Stick with it.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 26, 2016. 4      Please see “Powell Emphasizes Fed’s Independence,” The New York Times, June 25, 2019. 5      Heather Long, “Trump’s potential Fed pick Judy Shelton wants to see ‘lower rates as fast as possible’,” The Washington Post, June 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades