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Feature Recommended Allocation In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1).  Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4).   Chart 3A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Chart 6Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform Chart 8US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Chart 9Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016   Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates...   Chart 14...But Only As Far As 2.5%   Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Chart 16US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further     Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge   Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon.     Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2   Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3   For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation

Highlights The US-China trade talks will continue despite Hong Kong. The UK election will not reintroduce no-deal Brexit risk – either in the short run or the long run. European political risk is set to rise from low levels, but Euro Area break-up risk will not. There is no single thread uniting emerging market social unrest. We remain constructive on Brazil. Feature Chart 1Taiwan Indicator To Rise Despite Ceasefire President Trump signed the Hong Kong Human Rights and Democracy Act into law on November 27. The signing was by now expected – Trump was not going to veto the bill and invite the Senate to override him with a 67-vote at a time when he is being impeached. He does not want to familiarize the Senate with voting against him in supermajorities. The Hong Kong bill will not wreck the US-China trade talks, but it is a clear example of our argument that strategic tensions will persist and cast doubt on the durability of the “phase one trade deal” being negotiated. It is better to think of it as a ceasefire, as Trump’s electoral constraint is the clear motivation. Trump is embattled at home and will contend an election in 11 months. He will not impose the tariff rate hike scheduled for December 15. A relapse into trade war would kill the green shoots in US and global growth, which partly stem from the perception of easing trade risk. Only if Trump’s approval rating collapses, or China stops cooperating, will he become insensitive to his electoral constraint. Will China abandon the talks and leave Trump in the lurch? This is not our base case but it is a major global risk. So far China is reciprocating. Xi Jinping’s political and financial crackdown at home, combined with the trade war abroad, has led to an economic slowdown and an explosion in China’s policy uncertainty relative to America’s. A trade ceasefire – on top of fiscal easing – is a way to improve the economy without engaging in another credit splurge. The US and China will continue moving toward a trade ceasefire, despite the Hong Kong bill. The move toward a trade ceasefire will probably keep our China GeoRisk Indicator from rising sharply over the next few months. However, our Taiwan indicator, which we have used as a trade war proxy at times, may diverge as it starts pricing in the heightened political risk surrounding Taiwan’s presidential election on January 11, 2020 (Chart 1). Sanctions, tech controls, Hong Kong, Taiwan, North Korea, Iran, the South China Sea, and Xinjiang are all strategic tensions that can flare up. Yes, uncertainty will fall and sentiment will improve on a ceasefire, but only up to a point. China’s domestic policy decisions are ultimately more important than its handling of the trade war. At the upcoming Central Economic Work Conference authorities are expected to stay focused on “deepening supply-side structural reform” and avoiding the use of “irrigation-style” stimulus (blowout credit growth). But this does not mean they will not add more stimulus. Since the third quarter, a more broad-based easing of financial controls and industry regulations is apparent, leading our China Investment Strategy to expect a turning point in the Chinese economy in early 2020. This “China view” – on stimulus and trade – is critical to the outlook for the two regions on which we focus for the rest of this report: Europe and emerging markets. Assuming that China stabilizes, these are the regions where risk assets stand to benefit the most. Europe is a political opportunity; the picture in emerging markets is, as always, mixed. United Kingdom: Will Santa Bring A Lump Of Coal? The Brits will hold their first winter election since 1974 on December 12. Prime Minister Boris Johnson’s Conservative Party has seen a tremendous rally in opinion polls, although it has stalled at a level comparable to its peak ahead of the last election in June 2017 (Chart 2). Another hung parliament or weak Tory coalition is possible. Yet the Tories are better positioned this time given that the opposition Labour Party is less popular than two years ago, while the Liberal Democrats are more capable of stealing Labour votes. The Tories stand to lose in Scotland, but the Brexit Party of Nigel Farage is not contesting seats with them and is thus undercutting Labour in certain Brexit-leaning constituencies. Markets would enjoy a brief relief rally on a single-party Tory majority. This would enable Johnson to get his withdrawal deal over the line and take the UK out of the EU in an orderly manner by January 31. The question would then shift to whether Johnson feels overconfident in negotiating the post-Brexit trade agreement with the EU, which is supposed to be done by December 31, 2020. This date will become the new deadline for tariff increases, but it can be extended. Johnson is as unlikely to fly off the cliff edge next year as he was this year, and this year he demurred. Negotiating a trade agreement is easier when the two economies are already integrated, have a clear (yet flexible) deadline, and face exogenous economic risks. Our political risk indicator will rise but it will not revisit the highs of 2018-19 (Chart 3). The pound’s floor is higher than it was prior to September 2019. Chart 2Tories Look To Be Better Positioned For A Single Party Majority Chart 3UK Risk Will Rise, But Not To Previous Highs Bottom Line: A hung parliament is the only situation where a no-deal Brexit risk reemerges in advance of the new Brexit day of January 31. The market is underestimating this outcome based on our risk indicator. But Johnson himself prefers the deal he negotiated and wishes to avoid the recession that would likely ensue from crashing out of the EU. And a headless parliament can prevent Johnson from forcing a no-deal exit, as investors witnessed this fall. We remain long GBP-JPY. Germany: The Risk Of An Early Election Germany is wading deeper into a period of political risk surrounding Chancellor Angela Merkel’s “lame duck” phase, doubts over her chosen successor, and uncertainty about Germany’s future in the world. The federal election of 2021 already looms large. Our indicator is only beginning to price this trend which can last for the next two years (Chart 4). On October 27 Germany’s main centrist parties suffered a crushing defeat in the state election of Thuringia. For the first time, the Christian Democratic Union (CDU) not only lost its leadership position, but also secured less vote share than both the Left Party and the right-wing Alternative für Deutschland (AfD) (Chart 5, top panel). Chart 4Germany Is Heading Toward A Period Of Greater Political Risk The AfD successfully positioned itself with the right wing of the electorate and managed to capture more undecided voters than any other party (Chart 5, bottom panel). Chart 5The Right-Wing AfD Outperformed In Thuringia … While the rise of the AfD (and its outperformance over its national polling) may seem alarming, Germany is not being taken over by Euroskeptics. Both support for the euro and German feeling of being “European” is near all-time highs (Chart 6). The question is how the centrist parties respond. Merkel’s approval rating is at its lower range. Support for Annegret Kramp-Karrenbauer (AKK), Merkel’s chosen successor, is plummeting (Chart 7). Since AKK was confirmed as party chief, the CDU suffered big losses in the European Parliament election and in state elections. Several of her foreign policy initiatives were not well received in the party.1 In October 2019, the CDU youth wing openly rejected her nomination as Merkel’s successor. At the annual CDU party conference on November 22-23, she only narrowly managed to avoid rebellion. She is walking on thin ice and will need to recover her approval ratings if she wants to secure the chancellorship. Meanwhile the CDU will lose its united front, increasing Germany’s policy uncertainty. Chart 6... But Euroskeptics Will Not Take Over Germany Germany’s other major party – the Social Democratic Party (SPD) – is also going through a leadership struggle. Chart 7The CDU Party Leader Is Walking On Thin Ice Chart 8A Return To The Polls Would Result In A CDU-Green Coalition In the first round of the leadership vote, Finance Minister Olaf Scholz and Klara Geywitz (member of the Brandenburg Landtag) secured a small plurality of votes with 22.7%, just 1.6% more than Bundestag member Saskia Esken and Norbert Walter-Borjans (finance minister of North Rhine-Westphalia from 2010-17). The latest polling, and Scholz’s backing by the establishment, implies that he will win but this is uncertain. The results of the second round will be published on November 30, after we go to press. What does the SPD’s leadership contest mean for the CDU-SPD coalition? More likely than not, the status quo will continue. Scholz is an establishment candidate and supports remaining in the ruling coalition until 2021. Esken is calling for the SPD to leave the coalition, but Walter-Borjans has not explicitly supported this. An SPD exit from the Grand Coalition would likely lead to a snap election, not a favorable outcome for stability-loving Germans. A return to the polls would benefit the Greens and AfD at the expense of the mainstream parties, and would likely see a CDU-Green coalition emerge (Chart 8). Given that a majority of voters want the SPD to remain in government (Chart 9), and that new elections would damage the SPD’s prospects, we believe that the SPD is likely to stay in government until 2021, even if the less established Esken and Walter-Borjans win. The risk is the uncertainty around Merkel’s exit. October 2021 is a long time for Merkel to drag the coalition along, so the odds of an early election are probably higher than expected. Chart 9Germans Prefer The SPD Remains In Government Chart 10Climate Spending Closest Germany Gets To Fiscal Stimulus (For Now) Chart 11There Is Room For More Fiscal Stimulus In Germany, If Needed What would a Scholz win mean for the great debate over whether Germany will step up its fiscal policy? If the establishment duo wins the SPD leadership, the Grand Coalition remains in place, and the economy does not relapse, we are unlikely to see additional fiscal stimulus in the near future. Scholz argues that additional stimulus would not be productive, as the slowdown is due to external factors (i.e. trade war).2 The recently released Climate Action Program 2030 is the closest to fiscal stimulus that we will see. This package will deliver additional spending worth 9bn euro in 2020 and 54bn euro until 2023 (Chart 10). We are unlikely to see additional fiscal stimulus from Germany in the near future. Bottom Line: Germany is wading into a period of rising political uncertainty. In the event of a downward surprise in growth, there is room to add more fiscal stimulus (Chart 11). But there is no change in fiscal policy in the meantime, e.g. no positive surprise. France: Macron Takes Center Stage While Merkel exits, President Emmanuel Macron continues to position himself as Europe’s leader – with a vision for European integration, reform, and political centrism. But in the near term he will remain tied down with his ambitious domestic agenda. France is trudging down the path of fiscal consolidation. After exiting the Excessive Deficit Procedure in 2018, and decreasing real government expenditures by 0.3% of GDP, France’s budget deficit is forecasted to decline further (Chart 12). Macron’s government is moving towards balancing its budget primarily by reducing government expenditures to finance tax cuts and decrease the deficit. Macron’s reform efforts following the Great National Debate – tax cuts for the middle class, bonus exemptions from income tax and social security contributions, and adjustment of pensions for inflation – have paid off.3 His approval rating is beginning to recover from the lows hit during the Yellow Vest protests (Chart 13). These reforms will be financed by lower government expenditures and reduced debt burden as a result of accommodative monetary policy. Chart 12Fiscal Consolidation In France Chart 13Macron's Reform Efforts Have Paid Off Overall, France has proven to a very resilient country in light of a general economic slowdown (Chart 14, top panel). Business investment and foreign direct investment, propped up by gradual cuts in the corporate income tax rate, have remained steady, and confidence remains strong (Chart 14, bottom panels). France is consumer driven and hence somewhat protected from storms in global trade. Chart 14French Economy Resilient Despite Global Slowdown Chart 15Ongoing Strikes Will Register In French Risk Indicator Bottom Line: France stands out for remaining generally stable despite pursuing structural reforms. Strikes and opposition to reforms will continue, and will register in our risk indicator (Chart 15), but it is Germany where global trends threaten the growth model and political trends threaten greater uncertainty. On the fiscal front France is consolidating rather than stimulating.   Italy: Muddling Through This fall’s budget talks caused very little political trouble, as expected. The new Finance Minister Roberto Gualtieri is an establishment Democratic Party figure and will not seek excessive conflict with Brussels over fiscal policy. Italy’s budget deficit is projected to stay flat over 2019 and 2020. The key development since the mid-year budget revision was the repeal of the Value Added Tax hike scheduled for 2020, a repeal financed primarily by lower interest spending.4 Equity markets have celebrated Italy’s avoidance of political crisis this year with a 5.6% increase. Our own measure of geopolitical risk has dropped off sharply (Chart 16). But of course we expect it to rise next year given that Italy remains the weakest link in the Euro Area over the long run. The left-leaning alliance between the established Democratic Party and the anti-establishment Five Star Movement hurt both parties’ approval ratings. In fact, the only parties that have seen an increase in approval in the last month are the League, the far-right Brothers of Italy, and the new centrist party of former Prime Minister Matteo Renzi, Italia Viva (Chart 17). We expect to see cracks form next year, particularly over immigration, but mutual fear of a new election can motivate cooperation for a time. Chart 16Decline In Italian Risk Will Be Short Lived Chart 17The M5S-PD Alliance Damaged Their Approval Bottom Line: Italy’s new government is running orthodox fiscal policy, which means no boost to growth, but no clashing with Brussels either. Spain: Election Post Mortem Chart 18A Gridlocked Parliament In Spain The Spanish election produced another gridlocked parliament, as expected, with no party gaining a majority and no clear coalition options. The Spanish Socialist Workers’ Party (PSOE) emerged as the clear leader but still lost three seats. The People’s Party recovered somewhat from its April 2019 defeat, gaining 23 seats. The biggest loser of the election was Ciudadanos, which lost 47 seats after its highly criticized shift to the right, forcing its leader Alberto Rivera to resign. The party’s seats were largely captured by the far-right Vox party, which won 15.1% of the popular vote and more than doubled its seats (Chart 18). Socialist leader Pedro Sanchez has arranged a preliminary governing agreement with Podemos leader Pablo Iglesias, but it is unstable. Even with Podemos, Sanchez falls far short of the 176 seats he needs to govern. In fact, there are only three possible scenarios in which the Socialists can reach the required 176 seats and none of these scenarios are easy to negotiate (Chart 19). The first – a coalition with the People’s Party – can already be ruled out. The other two require the support of the smaller pro-independence party, which will be difficult for Sanchez to secure, given that he hardened his stance on Catalonia in the days leading up to the election. Chart 19No Simple Way To A Majority Government The next step for Sanchez is to be confirmed as prime minister in an “investiture” vote, likely on December 16.5 He would need 176 votes in the first round (or a simple majority in the second round) to gain the confidence of Congress. He looks to fall short (Chart 20).6 If he fails to be confirmed, Sanchez will have another two months to form a government or face the possibility of yet another election. Chart 20Sanchez Set To Fall Short In Investiture Vote Spain’s indecision is leading to small conflicts with Brussels. Last week, the European Commission placed Spain under the preventative arm of the Stability and Growth Pact, stating that the country had not done enough to reach its medium-term budget objective.7 The European Commission’s outlook on Spain is slightly more pessimistic than that of the Spanish government (Chart 21). Deficit projections could worsen if a left-wing government takes power that includes the anti-austerity Podemos – which means that Spain is the only candidate for a substantial fiscal policy surprise. Chart 21A Fiscal Policy Surprise In Spain? Chart 22Spanish Risk Will Keep Rising We expect our Spanish risk indicator to keep rising (Chart 22). The silver lining is that Spain’s turmoil – like Germany’s – poses no systemic risk to the Euro Area. Spain could also see an increase in fiscal thrust. Stay long Italian government bonds and short Spanish bonos. Bottom Line: We remain tactically long Italian government bonds and short Spanish bonos. Italian bonds will sell off less in a risk-on phase and rally more in a risk-off phase, and relative political trends reinforce this trade. Emerging Markets: Global Unrest Civil unrest is unfolding across the world, grabbing the attention of the global news media (Chart 23). The proximate causes vary – ranging from corruption, inequality, governance, and austerity – but the fear of contagion is gaining ground. Chart 23Pickup In Civil Unrest Raising Fear Of Contagion A country’s vulnerability to unrest can be gauged by two main factors: political voice and underlying economic conditions. • Political Voice: The Worldwide Governance Indicators, specifically voice and accountability, corruption, and rule of law, provide proxies for political participation (Chart 24). The aim is to assess whether there is a legitimate channel for discontent to lead to change. Countries with low rankings are especially at risk of experiencing unrest when the economy is unable to deliver. Chart 24Greater Risk Of Unrest Where Political Voice Is Absent • Economic Conditions: Last year’s tightening monetary conditions, the manufacturing and trade slowdown, the US-China trade war, and a strong US dollar have weighed on global growth this year. This is challenging, especially for economies struggling to pick up the pace of growth (Chart 25). It translates to increased job insecurity, in some cases where insecurity is already rife (Chart 26). The likelihood that economic deterioration spurs widespread unrest depends on both the level and change in these variables. The former political factor is a structural condition that becomes more relevant when economic conditions deteriorate. Chart 25The Global Slowdown Weighed On Growth In Regions Already Struggling … Chart 26… And Raise Job Insecurity Chart 27Brazilian Risk Unlikely To Reach Previous Highs BCA Research is optimistic on global growth as we enter the end game of this business cycle. Nevertheless risks to this view are elevated and emerging market economies are still reeling from the past year’s slowdown. This makes them especially sensitive to failures on the part of policymakers. As a result, policymakers will be more inclined to ease monetary and fiscal policy and less inclined to execute structural reforms. Brazil is a case in point. Our indicator is flagging a sharp rise in political risk (Chart 27). This reflects the recent breakdown in the real – which can go further as the finance ministry has signaled it is willing to depreciate to revive growth. Meanwhile the administration has postponed its proposals to overhaul the country’s public sector, including measures to freeze wages and reduce public sectors jobs. On the political front, President Jair Bolsonaro’s recent break from the Social Liberal Party and launch of a new party, the Alliance for Brazil, threatens to reduce his ability to get things done. This move comes at a time when Brazil’s political landscape is being shaken up by former president Luiz Inacio Lula da Silva’s release from jail, pending an appeal against his corruption conviction. The former leader of the Worker’s Party lost no time in vowing to revive Brazil’s left. Our risk indicator might overshoot due to currency policy, but we doubt that underlying domestic political instability will reach late-2015 and mid-2018 levels. Brazil has emerged from a deep recession, an epic corruption scandal, and an impeachment that led to the removal of former president Dilma Rousseff. It is not likely to see a crisis of similar stature so soon. Bolsonaro’s approval rating is the lowest of Brazil’s recent leaders, save Michel Temer, but it has not yet collapsed (Chart 28). An opinion poll held in October – prior to Lula’s release – indicates that Bolsonaro is favored to win in a scenario in which he goes head to head against Lula (Chart 29). Justice Minister Sergio Moro, who oversaw the corruption investigation, is the only candidate that would gain more votes when pitted against Bolsonaro. He is working with Bolsonaro at present and is an important pillar of the administration. So it is premature to pronounce Bolsonaro’s presidency finished. Chart 28Bolsonaro’s Approval, While Relatively Low, Has Not Collapsed Chart 29Bolsonaro Not Yet Finished The problem, as illustrated in Charts 25 and 26, is that Brazil still suffers from slow growth and an uninspiring job market – longstanding economic grievances. This will induce the administration to take a precautionary stance and slow the reform process. The result should be reflationary in the short run but negative for Brazil’s sustainability over the long run. There is still a positive path forward. Unlike the recently passed pension cuts and the public sector cuts that were just postponed – both of which zap entitlements from Brazilians – the other items on the reform agenda are less controversial. Privatization and tax reform are less politically onerous and will keep the government and economy on a positive trajectory. Meanwhile the pension cuts are unlikely to be a source of discontent as they will be phased in over 12-14 years. Thus, while the recent political events justify a higher level of risk, speculation regarding the likelihood of mass unrest in Brazil – apart from the mobilization of Worker’s Party supporters ahead of the municipal elections next fall – is overdone. Bottom Line: The growth environment in emerging markets is set to improve in 2020. US-China trade risk is falling and China will do at least enough stimulus to be stable. Moreover emerging markets will use monetary and fiscal tools to mitigate social unrest. This will not prevent unrest from continuing to flare. But not every country that has unrest is globally significant. Brazil is a major market that has recently emerged from extreme political turmoil, so a relapse is not our base case. Otherwise one should monitor Hong Kong’s impact on the trade deal, Russia’s internal stability, and the danger that Iranian and Iraqi unrest could cause oil supply disruptions. In the event that the global growth rebound does not materialize we expect Mexico and Thailand – which have better fundamentals – to outperform. Our long Thai equity relative trade is a strategic defensive trade.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “Merkel’s Successor Splits German Coalition With Rogue Syria Plan,” dated October 22, 2019 and “Merkel's Own Party Wants Outright Huawei Ban From 5G Networks,” dated November 15, 2019, available at bloomberg.com. 2 Please see “Scholz Says No Need for German Stimulus After Dodging Recession,” dated November 14, 2019, available at bloomberg.com. 3 Please see “France: Draft Budgetary Plan For 2020,” dated October 15, 2019, available at ec.europa.eu. 4 Please see “Analysis of the Draft Budgetary Plan of Italy,” dated November 20, 2019, available at ec.europa.eu. 5 Please see “Investiture calendar | Can a government be formed before Christmas?” dated November 14, 2019, available at elpais.com. 6 If Sanchez convinces PNV, BNG, and Teruel Exists to vote in his favor for both rounds of the vote, he would need ERC and Eh Bildu to abstain in order to win. However, given that the PSOE has stated that it will not even negotiate with Eh Bildu, it is likely that this party will vote against Sanchez, giving the opposition 168 votes. In this case, Sanchez would not only need PNV, BNG, and Teruel in his favor, but also the support of either CC or ERC, both unlikely scenarios. 7 Please see “Commission Opinion on the Draft Budgetary Plan of Spain,” dated November 20, 2019, available at ec.europa.eu. Appendix Germany: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator  Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar

Special Report

Highlights Net inflows into US assets have been rolling over since the beginning of 2019, given that the repatriation associated with the 2017 tax cuts was a one-off effect. Besides, fading interest rate differentials are making US Treasuries less attractive, which is a headwind for the greenback.  A trade war ceasefire between the US and China should improve the balance of payments dynamics for export-oriented nations. We maintain a pro-cyclical stance.  A revival in oil demand and curbs on supply should underpin oil prices through 2020, which could lift the trade balances of Norway and Canada. However, we expect the Canadian dollar to underperform, weighed by pipeline constraints and the divergence between WCS and WTI prices. Stay short CAD/NOK. Feature The balance of payments is one of the key indicators we watch on a regular basis to gauge the direction of exchange rates. While the power of BoP on currency moves differs from one country to another, it provides a big picture view of a country's transactions with other nations. Generally speaking, persistent surpluses are usually associated with appreciation in currencies, and vice versa. Ongoing trade disputes since early 2018 have caused some fluctuation in current account balances globally. Political uncertainties and rising protectionism have also limited foreign investments in some countries. Going forward, should global growth stabilize amid a possible trade détente, export-oriented regions will have more scope to improve their balance of payments dynamics. In what follows we present balance of payments across G10 through five categories: the trade balance, the current account balance, foreign direct investment, the basic balance, and lastly, portfolio investment. United States Chart 1US Balance Of Payments The US trade deficit has been more or less flat, lingering around 3% of GDP. The trade deficit mostly comes from manufactured goods. On the positive side, the US has been producing and exporting more petroleum and related products, which has decreased oil demand from abroad. Meanwhile, exports of pharmaceutical products are on the rise. The current account is at a smaller deficit of 2.5% of GDP, thanks to a positive net international investment position. Foreign direct investment had been increasing due to repatriation by US companies since the 2017 Trump tax cuts. If this one-off tax break was a source of US dollar strength in 2018, that support is now gone. Meanwhile, dollar strength since the beginning of 2018 may have made US assets less attractive to foreign investors. Since the beginning of 2019, net inflows into US assets have been rolling over, and have fallen to 0.9% of GDP. This has brought the US basic balance down to -1.6% of GDP. In terms of portfolio investment, US bond markets are still appealing to foreign investors, but interest rate differentials are moving against the greenback. Total foreign purchases of US Treasury bonds have been negative this year, of which official purchases stand at US$350 billion of net outflows. In short, the path of least resistance for the US dollar is down, due to a widening current account deficit, waning foreign direct investment, fading interest rate differentials and increasing dollar liquidity. Euro Area Chart 2Euro Area Balance Of Payments The slowdown in global trade has hit European exports, but the trade balance is still sporting a “healthy” surplus of 1.7% of GDP, albeit far below its peak. As a result, the current account as of September 2019 was still at a healthy level of 2.7% of GDP. Should a US-China "phase one" deal be finalized, the trade balance in the euro area is likely to rebound going into 2020. Foreign direct investment has been increasing to the point of being at its highest level over the past 20 years, or 1% of GDP. This has been aided in part by the peripheral countries, further evidence that we are getting a convergence in competitiveness across Eurozone countries. The cheap euro and lower cost of capital have helped. As a result, the basic balance for the euro area reached a new high of 3.8% of GDP in September 2019. Portfolio investment into the euro area has stopped deteriorating since the beginning of 2017 and is now sporting net inflows of 0.8% of GDP. European purchases of both foreign equities and foreign bonds are falling, probably a sign that domestic assets are becoming more attractive. For example, ETF inflows are accelerating. The restart of the European Central Bank’s asset purchase program will continue to act as an anchor for spread convergence in the euro area. Meanwhile, a rally in European equities will be another signal of recovery in the euro area. A healthy current account balance and improving foreign investments both signal a higher euro going forward. Japan Chart 3Japanese Balance Of Payments The trade slowdown has dealt a small blow to Japan’s current account balance. The trade deficit widened further in 2019, reaching -0.5% of GDP in Q3. Exports have been falling for a 10th consecutive month, weighed down in part by lower sales of auto parts and semiconductor equipment. But these will pick up should a trade truce be reached. Among its major trading partners, sales to the US, China and other Asian countries have fallen, but have risen in the Middle East and Western Europe. That said, Japan’s large net international investment position has helped keep the current account surplus at an elevated level of 3.4% of GDP. Foreign direct investment in Japan has been dismal for many years due to an offshoring of industrial production. Net FDI is currently standing at -4% of GDP, which has brought the basic balance below zero for the first time since 2016. The recent deceleration is further evidence that corporate Japan needs structural reforms. Portfolio investment remains in negative territory mostly due to Japanese residents' large purchases of foreign long-term bonds. Going forward, fund inflows to Japan could face more headwinds with the proposed change to the Foreign Exchange and Foreign Trade Act. The change aims to lower the minimum stake for foreign investors without government approval from 10% to 1%. Other changes include requiring foreign directors to seek permission before becoming a board member. That said, Japan’s large net international investment position, which produces a high current account surplus, will continue to make the yen a safe haven amid global uncertainties. United Kingdom Chart 4UK Balance Of Payments So far, a cheap pound has not yet staunched the deterioration in UK balance of payments. The UK trade deficit remained wide at 7% of GDP in the third quarter. Among its major trading partners, the trade deficit comes mainly from Germany and China, offset by a smaller surplus from the US, the Netherlands and Ireland. Net receipts are positive, but the current account balance is still in negative territory at -5% of GDP. The Brexit imbroglio has led to an exodus of foreign direct investment. Many international companies are fleeing the UK, but to the extent that we get a quick resolution after the December elections, the uncertainty is likely to subside. Portfolio investment in the UK has been volatile over the past few years and has not really helped dictate any discernable trend in the UK basic balance. More recently, inflows into UK gilts have been £19 billion in the second quarter, while flows into equities are also improving. Relative interest rate differentials are also likely to move in favor of the UK, especially if reduced uncertainty provides scope for the Bank of England to hike interest rates. At a minimum, compared with other European nations, gilts remain appealing to international investors. We remain positive on the pound and are long GBP/JPY in our portfolio. Canada Chart 5Canadian Balance Of Payments The Canadian trade deficit has been hovering near -1% of GDP over the past few years. The goods trade deficit narrowed this year, led mostly by an increase in energy exports and lower imports of transportation equipment. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between WCS and Brent crude oil prices. The current account deficit has been narrowing, now standing at -2% of GDP, the smallest since 2008. This is helped by net receipts, especially driven by a rise in direct investment income. FDI has been the bright spot in Canadian BoP dynamics. FDI inflows have been in part helped by increased cross- border M&A activities. Net FDI into Canada now accounts for 2.7% of GDP. This has brought the basic balance back above zero for the first time since 2015. Portfolio investment is positive on a net basis, but the trend looks quite worrisome. Foreign entities are fleeing Canada. In the meantime, Canadian investment in foreign securities is on the rise, reaching C$6 billion in Q3. Profitability, liquidity concerns and a global push towards sustainable investing are making Canadian energy and mining companies unappealing for foreign capital. Moreover, with elevated house prices and depressed interest rates, the outlook for banking profitability is also concerning. A drop in the US dollar will help the loonie in the short term. Over the longer term, however, we prefer to be underweight the Canadian dollar, especially via the Australian dollar and the Norwegian krone, which have a better macro outlook. Australia Chart 6Australian Balance Of Payments Australia has seen the best balance of payments improvement among the G10. The Australian trade balance soared this year and now stands at 2.5% of GDP, the highest in several years. Terms of trade, which have increased by 45% since their 2016 bottom, have been one of the main drivers. Exports of iron ore and concentrates increased by 64% year-on-year in September 2019, adding to the positive trade balance. Ergo, Australia is benefitting from both a price and volume boost. Trade has lifted the current account to be on track to post its first surplus since the ‘70s. Going forward, we expect Australian trade to continue improving amid the US-China trade détente. Foreign direct investment dipped slightly in 2019, but from very elevated levels. At present, it still stands at 3.5% of GDP. This has allowed for a very healthy basic balance surplus of 2.9% of GDP. The largest sources of Australian foreign direct investment are the US and the UK. The FDI inflows tend to be concentrated in the mining and manufacturing sectors and generate a negative income balance for Australia. This has been part of the reason behind the country’s chronic current account deficit, but it is impressively becoming less and less important. Portfolio investment in Australia plunged in 2019, and now stands at -4.2% of GDP. This has been driven by an exodus from the bond market. The repatriation of capital back to the US probably helped exacerbate this trend. The Australian dollar is likely to rebound from a contrarian perspective. We are playing Aussie dollar strength via the New Zealand and Canadian dollars. New Zealand Chart 7New Zealand Balance Of Payments New Zealand is also benefitting from a terms-of-trade boost. The trade deficit marginally narrowed to -1.7% of GDP in the third quarter. Exports rose by 4% year-on-year in the third quarter, while imports rose by 3.6% year-on-year. Terms of trade increased in 2019, mainly driven by a rise in dairy and meat prices. It appears the pork crisis in China is benefitting New Zealand exports. As a result, the current account deficit narrowed slightly to 3.4% of GDP. Foreign direct investment in New Zealand rose sharply to 3.1% of GDP, partly driven by reinvestment in the banking sector. This almost brought the basic balance back into positive territory. If this trend continues, it will be the first time the basic balance is in positive territory in two decades. Portfolio investment in New Zealand has been deteriorating, with net outflows of $6.2 billion in the second quarter. This is almost 4% of GDP on an annualized basis. The withdrawal of equity and investment fund shares by foreign entities, as well as divestment of debt securities by the general government, are some of the reasons behind falling portfolio investment. In a nutshell, increased portfolio investment in New Zealand will be predicated on a terms-of-trade shock that boosts margin growth for agricultural exporters, or a policy shift that boosts domestic return on capital. We like the kiwi versus the dollar, but are underweight against its pro-cyclical peers, namely the Australian dollar and the Swedish krona. Switzerland Chart 8Swiss Balance Of Payments The Swiss trade balance has been in a structural surplus, and hugely underpins the nation’s large current account surplus. The improvement this year, a rebound to 5.4% of GDP in the third quarter, is notable. The increase in exports has been partly driven by higher sales of chemical and pharmaceutical products, jewelry, and metals. Combined with income inflows from its large net international investment position, this has produced a current account balance of 10.7% of GDP. The slowdown in foreign direct investment has eased sharply from a record-low of -16% to -8% of GDP. Tax breaks from the US Jobs Act in 2017 allowed for favorable divestment of FDI in Switzerland and repatriation back to the US. This was a one-off that is now behind us, which explains why the basic balance is shifting back into surplus territory, to the tune of 2.5% of GDP.  Portfolio investment has been gradually improving and now stands at 0.3% of GDP. Swiss paper and equities (which are defensive) have benefitted from increased safe-haven demand this year. The Swiss franc is likely to continue its slow structural appreciation in the years to come, interspersed with bouts of volatility. In the short-term, however, the Swiss National Bank is likely to use the currency to fight deflationary pressures. This suggests the EUR/CHF has upside tactically. Sweden Chart 9Swedish Balance Of Payments The Swedish trade balance has been in structural decline since 2004 and turned negative in 2016. A large component of Swedish exports are machinery and automobiles which have suffered stiff competition from other global giants. The good news is that the weak krona is starting to help. The third-quarter trade balance shifted to a surplus for the first time since 2016 and is currently standing at 0.2% of GDP. Combined with inflows from Sweden’s external investments, this has nudged the current account balance to 3.3% of GDP. Despite net FDI inflows falling to -2.1% of GDP, the basic balance still managed to remain stable at 1.2% of GDP due to the improvement in the current account balance. The recent decline in Swedish FDI has mirrored those in other countries. However, Swedish exports will benefit from a trade détente as well as from a broader improvement in global growth. This should stem FDI outflows. Net portfolio investment in Sweden has been volatile in recent years, but our expectation is for improvement. A weak krona has typically helped the manufacturing sector with a lag of 12 months. Moreover, with the krona trading at a large discount to its long-term fair value, foreign investors will likely benefit from both equity and currency returns, should cyclical stocks continue to outperform defensives. In summary, Sweden’s basic balance should recover to levels that have prevailed over the past few years. Norway Chart 10Norwegian Balance Of Payments The bottom in oil prices since 2016 has gone a long way towards improving Norway’s trade balance. Net trade has fallen marginally this year due to lower exports of oil and natural gas, but still stands at 7.2% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 6.4% of GDP. Norway has seen an exodus of foreign capital from both direct and portfolio investment.  Net FDI and portfolio investment stand at -3% and -4% of GDP, respectively. Declining oil production in the North Sea has been partly responsible for falling FDI. On the portfolio side of the equation, it has been mainly due to increased purchases of foreign equities and bonds, especially via the Oil Fund. Concerns around sustainable investing have also likely diverted investors away from Norwegian assets. Despite this, Norway still sports a basic balance surplus of 3.4% of GDP. Eventually, this basic balance will move from being supported by trade to income inflows from Norway’s large net international investment position. The Norwegian krone is cheap on many metrics, and is one of our favorite petrocurrencies at the moment. Should global growth stabilize, which will revive oil demand, inflows into Norway should improve.   Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, In addition to this short weekly report, you will also receive our 2020 outlook, published by the Bank Credit Analyst. Next week, I will be on the road visiting clients in South Africa. I hope to report my discussions and findings the following week. Best regards, Chester Ntonifor Highlights According to a simple attractiveness framework, the most desirable currencies are the Norwegian krone, the Swedish krona, and the Japanese yen. The least attractive are the New Zealand dollar and the British pound. Take profits soon on our long GBP/JPY position. Feature In this report, we use a simple framework for ranking G10 currencies. First, we consider the macroeconomic environment using as proxies a country’s basic balance and external vulnerability. Next, we look at valuation metrics,  surveying a variety of both short-term and longer-term models. Finally, we consider positioning, to gauge if our view is mainstream or out of consensus. Below are our results. Basic Balance Chart I-1Basic Balance We consider the basic balance to be one of the most important concepts in determining the attractiveness of a currency. In a nutshell, it captures the ebb and flow of demand for a country’s domestic assets. Persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. The euro area sports the best basic balance surplus in the G10 universe, followed by Norway and then Australia (Chart I-1). In simple terms, this means there is constant strong underlying demand for these currencies - either for domestic goods and services, or for investment into portfolio assets. The UK and the US rank the worst in terms of basic balances, driven by Brexit uncertainty and the ebbing of tax reform benefits in the US. We will explore balance of payments dynamics within all of the G10 countries in detail next week. External Debt A currency is sometimes only as vulnerable as its external liabilities. In an absolute sense, external debt as a share of GDP is highest in the UK, euro area, and Switzerland (Chart I-2). However, what matters most times for vulnerability are net external assets rather than gross liabilities. On this measure, Japan, Switzerland, and Norway are the most attractive countries, while the US and Australia rank the worst (Chart I-3). Chart I-2External Vulnerability Chart I-3US Is Least Attractive Purchasing Power Parity (PPP) Chart I-4PPP Model Various models have shown PPP to be a very poor tool for managing currencies, but an excellent one at extremes. However, there is a roadblock that comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone.  The results show the US dollar as overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc. The euro is less undervalued than implied by the overvaluation in the DXY index (Chart I-4). Intermediate-Term Timing Model (ITTM) Back in 2016, we developed a set of currency indicators to help global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar. Our intermediate-term timing models are not sending any strong signals at the moment.  Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. Chart I-5Intermediate-Term Model Inflation Differentials: Assuming no transactional costs, the price of sandals cannot be relatively high and rising in Mumbai versus Auckland. Either the Indian rupee needs to fall, the kiwi rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are not government bonds in that few treasury departments and central banks can guarantee a par value on them. Ergo, the ebb and flow of risk aversion will have an impact on the Norwegian krone as well as the yen. For the most part, our models have worked like a charm. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. That said, our intermediate-term timing models are not sending any strong signals at the moment. The Swedish krona, Norwegian krone, and New Zealand dollar are the most attractive currencies, while the British pound and Swiss franc are the least attractive (Chart I-5). Long-Term Fair Value Model Chart I-6Long-Term Model Our long-term FX models are also part of a set of technical tools we use to help us navigate FX markets. Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their main purpose is to provide information on the longevity of a currency cycle, depending on where we are in the economic cycle. Our long-term FX models are not sending any strong signals right now, with the US dollar at fair value. The cheapest currencies are the yen, the Norwegian krone, and Swedish krona (Chart I-6). The priciest currencies are the South African rand and the Saudi riyal. Real Interest Rates One defining feature of the currency landscape is that pretty much across the G10 countries, we have negative real rates (Chart I-7). Within  the G10 universe, the US and New Zealand dollars are the highest-yielding currencies, while the British pound and Swedish krona are the least attractive. Chart I-7Real Rates Speculative Positioning Being long Treasurys and the dollar has been a consensus trade for many years now (Chart I-8). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. Chart I-8Positioning That said, flow data highlights just how precarious being long US dollars is right now. Net foreign purchases by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Concluding Thoughts Should the nascent pickup in global growth morph into a synchronized recovery, it will go a long way in further eroding the US’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. For example, yields in Norway, Sweden, Switzerland, and Japan have risen by much more than those in the US since the bottom. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar. This is the message being sent by an aggregate of our ranking model. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar (Chart I-9). Take profits soon on our long GBP/JPY position. Chart I-9Favor Norway, Japan and Sweden   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Retail sales grew by 0.3% year-on-year in October. Industrial production contracted by 0.8% month-on-month in October. On the housing market front, building permits and housing starts both increased by 5% and 3.8% month-on-month in October. However, MBA mortgage applications contracted by 2.2% for the week ended November 15th. The NY Empire State Manufacturing index fell to 2.9 from 4 in November. The Philly Fed manufacturing index, on the other hand, soared to 10.4 from 5.6 in November. The DXY index depreciated by 0.3% this week. The FOMC minutes released this Wednesday showed that the Fed now sees little need to further reduce rates. Last week, we did a reassessment of global growth and the USD, and entered a limit sell for the DXY index at 100. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4UR Technicals 2 Recent data in the euro area have been mostly positive: The seasonally-adjusted trade balance fell to €18.3 billion in September. The current account surplus slightly narrowed by €0.3 billion to €28.2 billion. Headline and core inflation were both unchanged at 1.1% and 0.7% year-on-year respectively in October. Consumer confidence improved from -7.6 in October to -7.2 in November. EUR/USD increased by 0.5% this week. The improvement in soft data confirms that the economy is in a bottoming process in the euro area. The fact that the largest economy, Germany, skirted a recession last week also boosted investor confidence. We continue to remain overweight the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Exports decreased by 9.2% year-on-year in October. Imports slumped by 14.8% year-on-year. The total trade balance shifted to a surplus of ¥17.3 billion.  The industry activity index increased by 1.5% month-on-month in September. USD/JPY fell by 0.2% this week. While global growth is set to improve given a possible trade détente and easy monetary policy worldwide, uncertainties continue to loom. The US Senate unanimously passed legislation on the "Hong Kong Human Rights and Democracy Act," adding more difficulties to finalize the Phase I trade deal. Global trade uncertainty is positive for safe-haven demand. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index increased by 0.3% year-on-year in November. Public sector net borrowing increased by £3 billion to £10.5 billion in October. The British pound continues to appreciate by 0.7% against the US dollar this week. With Brexit being less of a threat, the pound is poised to rise through next year. We are long GBP/JPY in our portfolio and it is in the money at 6.1%. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been soft: The Westpac leading index fell by 0.1% month-on-month in October, following a slight decline the previous month. AUD/USD has been more or less flat this week. In the monetary policy minutes released this week, the RBA expressed their expectations for stronger growth at 2.75% in 2020 and around 3% in 2021, supported by accommodative monetary policy, infrastructure spending, stabilizing house prices, and strong steel-intensive activities in China. The minutes also presented an argument against lower interest rates: while lower interest rates can support the economy through the usual transmission channels, they could be negative for savers and confidence. That said, the RBA is "prepared to ease monetary policy further if needed." Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Both output and input components of the producer price index have increased in Q3: the output component grew by 1% quarter-on-quarter and input component by 0.9% quarter-on-quarter. NZD/USD increased by 0.7% this week. Both growth and inflation in New Zealand are showing signs that the economy is in a bottoming process. We are positive on the kiwi against the US dollar while we remain short against the Australian dollar and Swedish Krona. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Manufacturing shipments fell by 0.2% month-on-month in September. Both headline and core inflation were unchanged at 1.9% year-on-year in October. ADP employment showed a loss of 22.6K jobs in October. The Canadian dollar fell by 0.6% against the US dollar this week. While a possible trade détente between US and China and rising oil prices could put a floor under the loonie, the pipeline constraints in Canada have dampened the correlation between the oil prices and the loonie.  This will limit the upside potential for the Canadian dollar. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus narrowed to CHF 3.5 billion in October from CHF 4.1 billion the previous month, due primarily to growth in imports, which grew by 1.9 billion month-on-month. Exports also increased by 1.3 billion month-on-month. Import demand remains firm for chemical products. Industrial production grew by 8% year-on-year in Q3. USD/CHF increased by 0.2% this week. The trade balance still remains at a high level in Switzerland, which is bullish for the franc. Moreover, global uncertainties could underpin the safe-haven franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The trade balance shifted to a surplus of NOK 5.9 billion in October, after a deficit of NOK 1.4 billion in September. However, this is compared to a surplus of NOK 32.6 billion in the same month last year. On a year-on-year basis, exports slumped by 27%, caused by a decrease in exports of mineral fuels and chemical products. The Norwegian krone appreciated by 0.3% against the US dollar this week, supported by the oil price recovery. On Wednesday, the EIA posted an increase of crude oil inventories by 1.4 million barrels from the previous week, lower than expectations. WTI crude oil prices thus surged by 4% on the news. Going forward, we remain overweight energy prices and the Norwegian krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased to 0.5% in Q3, up from 0.1% in the previous quarter. The Swedish krona increased by 0.7% against the US dollar this week. The Swedish krona has depreciated by 23% against the USD since its 2018 peak. A global growth revival is likely to give a boost to the krona from a valuation perspective. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM.  Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors     The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth   Chart 6China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6).  Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth     Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth.   Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating       Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand.   Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15).     Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives       We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves   Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector   U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018).   Strategy & Market Trends MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades

In lieu of the next weekly report I will be presenting the quarterly webcast ‘The Japanification Of Europe: Should We Fear It, Or Celebrate It?’ on Monday 4 November at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Regards, Dhaval Joshi Highlights Global and European growth is experiencing a welcome rebound. Favour a cyclical investment stance, albeit tactical – as there is no visibility in the growth rebound beyond early 2020. Close the overweight to healthcare versus industrials at a small profit. Upgrade Sweden and Spain to overweight, and Norway to neutral. Downgrade Denmark to underweight, and Ireland to neutral. Expect heightened volatility in sterling in the build up to a highly ‘non-linear’ UK election. Fractal trades: 1. long oil and gas versus telecom; 2. long tin. Feature Global and European growth is experiencing a welcome rebound. This we can see from the best real-time indicators of activity, such as the ZEW sentiment, IFO expectations and of course the equity and bond markets (Chart of the Week). Nevertheless, investors make three very common mistakes in interpreting, predicting, and implementing such rebounds. This week’s report describes these three mistakes and the underlying realities. Chart of the WeekGrowth Is Experiencing A Welcome Rebound Mistake #1: Real-Time Indicators Do Not Lead The Market Reality #1: In the short term, markets move in lockstep with indicators such as the ZEW sentiment, IFO expectations, and PMIs (Chart I-2). Chart I-2Economic Indicators Do Not Lead The Markets... Having said that, the evolution of economic indicators can still provide a useful long-term investment signal. If an indicator – like IFO expectations – tends to revert to its mean, and is now near its historical lower bound, the scope for an eventual move up is greater than the scope for a further move down.1 Based on such a reversion to the mean, we are maintaining a structural overweight to the DAX versus the German long bund (Chart I-3). Chart I-3...But Depressed Performances Have Scope For Long-Term Upside But to reiterate, in the short term, the market moves in lockstep with the real-time economic indicators. Hence, to get a useful short-term investment signal, we need to predict where these indicators will be in the coming months – in other words, to predict whether growth will continue to accelerate. In the short term, the market moves in lockstep with real-time economic indicators.  Which brings us neatly to the second mistake. Mistake #2: When Financial Conditions Ease, Growth Does Not Necessarily Accelerate Reality #2: It is not the change of financial conditions but rather its impulse – the change of the change – that causes growth to accelerate or decelerate. For example, a 0.5 percent decline in the bond yield decline will trigger new borrowing through, inter alia, an increase in the number of mortgage applications. The new borrowing will add to demand, meaning it will generate growth. But in the following period, a further 0.5 percent decline in the bond yield will generate the same additional new borrowing and thereby the same growth rate. The crucial point being that if the decline in the bond yield is the same in the two periods, growth will not accelerate. Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. But growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. To repeat, the counterintuitive thing is that for a growth acceleration it is not the change in the bond yield that is important but rather its impulse. There are four impulses that matter for short-term growth: The bond yield 6-month impulse. The credit 6-month impulse. The oil price 6-month impulse (for oil importing economies like Germany). The geopolitical risk impulse. To be clear the geopolitical risk impulse is not an impulse in the technical sense, but it is a similar concept: is the number of potential geopolitical tail-events going up or down? In the fourth quarter, our subjective answer is down. The Brexit deadline has been pushed back to January 31 2020; the new coalition government in Italy has removed Italian politics as an imminent tail-event; and the US/China trade war and Middle East tensions are most likely to be in stasis. Turning to the other impulses, the credit 6-month impulse should briefly rebound in the fourth quarter following the rebound in the global bond yield 6-month impulse (Chart I-4). All of this favours a cyclical investment stance – albeit tactical, because there is no visibility in this growth rebound beyond early 2020. Chart I-4The Credit 6-Month Impulse Should Briefly Rebound Meanwhile, the recent evolution of the oil price 6-month impulse should provide an additional short-term tailwind for oil importing economies (Chart I-5). Justifying a near-term overweight stance to the cyclical heavy German stock market within a European or global equity portfolio. Chart I-5The Oil Price 6-Month Impulse Should Help Oil Importing Economies Which brings us to the third mistake. Mistake #3: Major Stock Markets Are Not Plays On Their Economies Of Domicile Reality #3: Major stock markets are dominated by multinational corporations, and such companies are plays on their global sectors, rather than the country in which they have a stock market listing. Hence, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. What confuses matters is that sometimes the sector fingerprint happens to align with the tilt of the domicile economy. Germany has an exporter heavy stock market and an exporter heavy economy while Norway has an oil heavy stock market and an oil heavy economy, so in these cases there is a connection between the stock market and the economy. But in most instances, there is no alignment: the connection between the UK stock market and the UK economy is minimal, and the same is true in Spain, Denmark, Ireland, and most other countries. When bond yields were declining most sharply, and growth was decelerating, it weighed on cyclical sectors such as industrials and banks versus the more defensive sectors such as healthcare. Banks suffered doubly because the flattening (or inverting) yield curve also ate into their margins. But if the sharpest decline in bond yields has already happened, it suggests that cyclicals could experience a burst of outperformance, at least for a few months (Chart I-6). Hence, today we are closing our four month overweight to healthcare versus industrials at a small profit. Chart I-6If The Sharpest Decline In Bond Yields Is Over, Cyclicals Could Outperform Based on sector fingerprints, this also necessitates the following changes to our country allocation: Overweight banks versus healthcare means overweight Sweden versus Denmark (Chart I-7). Chart I-7Long Sweden Versus Denmark = Long Financials And Industrials Versus Biotech Overweight banks means overweight Spain (Chart I-8). Chart I-8Long Spain = Long Banks Meanwhile, removing our underweight to the cyclical oil sector means removing the successful underweight to Norway (Chart I-9). And indirectly, it means removing the equally successful overweight to Ireland, given its high weighting to Airlines (Chart I-10).  Chart I-9Long Norway = Long Oil And Gas Chart I-10Long Ireland = Long Airlines   Bonus Mistake: You Can Not Hit A Point Target In A Non-Linear System Boris Johnson said that he “would rather be dead in a ditch” than miss the October 31 deadline for delivering Brexit. Well Johnson had to ditch his ditch. Why? Because the UK’s parliamentary arithmetic has made Brexit an inherently non-linear system, and you cannot hit a point target in a non-linear system. Boris Johnson had to ditch his ditch. In a non-linear system a tiny change in an input might have no impact on the output, or it might have a huge impact on the output. The Brexit process is inherently non-linear because a tiny shift in parliamentary votes one way or another, or a tiny shift in the tabled amendments to laws one way or another has had a huge impact on the outcome. That’s why it proved impossible for Johnson to hit his point target of delivering Brexit by October 31. Attention now shifts to another non-linear system – the upcoming UK general election. The UK’s first past the post electoral system is designed for a head-to-head between two dominant parties. But right now, there are five parties in play – Labour, Liberal Democrat, Conservative, Brexit, plus the SNP in Scotland. Mathematically, this creates the possibility of ten types of swings, compared with the usual single swing between Labour and Conservative. Making the outcome of the election highly sensitive to a tiny shift in votes either way in ten different directions. The UK general election is a non-linear system. In The Pound Is A Long Term Buy (And So Are Homebuilders) we initiated a structural long position in the undervalued pound.2 Given that our overweight to the international focused FTSE100 versus the domestic focussed FTSE250 is effectively an inverse play on the pound, it is inconsistent with our long-term view on the currency (Chart I-11). Nevertheless, over the course of the election campaign we expect heightened volatility in sterling as the non-linearity of the election outcome becomes clear. Hence, we await an upcoming better opportunity to remove our overweight FTSE100 versus FTSE250 position. Chart I-11Long FTSE250 Versus FTSE100 = Long Pound Fractal Trading System* There are two recommended trades this week. The underperformance of US oil and gas versus telecom is ripe for a technical rebound based on its broken 130-day fractal structure. Go long US oil and gas versus telecom, setting a profit target and symmetrical stop-loss at 8 percent. The recent sell-off in tin is undergoing a similar technical bottoming process. Go long tin, setting a profit target and symmetrical stop-loss at 5 percent. 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. Chart I-12US: Oil & Gas Vs. Telecom Chart I-13Tin 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 In technical terms, if the time-series is ‘stationary’, it must eventually rebound from its lower bound. 2 Please see the European Investment Strategy Weekly Report, "The Pound Is A Long-Term Buy (And So Are Homebuilders)," dated October 17, 2019 available at eis.bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations 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  

Highlights Declining uncertainty over policy, stabilizing growth in China and improvements in international liquidity, all will allow global economic activity to pick up in the months ahead. A weak dollar will reinforce this positive economic outlook; investors should favor pro-cyclical currencies such as the AUD, NZD and SEK. Bond yields will rise and stocks will outperform bonds on a 12- to 18-month basis. Cyclical stocks are more attractive than defensives. European stocks will outperform U.S. equities and European financials will shine. Copper is a promising buy; stay long the silver-to-gold ratio. Feature The outlook for risk assets and bond yields hinges on global economic activity. The S&P 500 has hit a new high, but our BCA Equity Scorecard Indicator remains non-committal towards stocks (Chart I-1). If global economic activity improves, the Scorecard will begin to flash a clear buy signal, but if growth deteriorates, the indicator will point towards sell. Chart I-1Stocks Could Go Either Way Cautious optimism is in order. Politics, China, liquidity conditions and the dollar collectively will determine the global economic outlook. The liquidity backdrop has significantly improved, political uncertainty should recede and China will morph from a headwind to a modest tailwind. A weak dollar will indicate that the world is healing, and also will ease global financial conditions which will facilitate economic strength. We remain committed to a positive stance on equities on a 12- to 18-month horizon, and recommend below-benchmark duration in fixed-income portfolios. Cyclicals should outperform defensives, European banks offer an attractive tactical buying opportunity and European equities will outperform their U.S. counterparts. Heightened Risks… Chart I-2Risks To The Economy And Stocks Many domestic indicators overstate the intrinsic fragility in the U.S. The Duncan LEI, which is the ratio of consumer durable spending and residential and business investment to final sales, has flattened. Therefore, the S&P 500 looks vulnerable and real GDP may contract (Chart I-2). CEO confidence and small business capex intentions warn of a looming retrenchment in household income (Chart I-2, bottom two panels). If consumer spending weakens, then a recession will be unavoidable. As worrisome as these indicators may be, we previously discussed that the major debt imbalances that often precede U.S. recessions are absent,1 the rebound in housing starts and homebuilding confidence is inconsistent with a restrictive monetary stance,2 and pipeline inflationary pressures are absent.3 Instead, business confidence and the Duncan LEI have been eroded by heightened political uncertainty and weak global manufacturing and trade. … Meet Receding Policy Uncertainty … The two biggest sources of policy uncertainty affecting markets, the Sino-U.S. trade war and Brexit, are diminishing. However, the U.S. election will continue to lurk in the background. Chart I-3Weaker Brexit Support = No Hard Brexit Support Brexit Westminster and Britain’s Supreme Court have rebuked U.K. Prime Minister Boris Johnson’s threat of a “No-Deal” Brexit. Moreover, parliamentary support for his latest plan, which essentially keeps Northern Ireland’s economy within the EU, indicates that the probability of a “No-Deal” Brexit has collapsed to less than 5%. This assessment is reinforced by the delay of Brexit to January 31, 2020. An election is scheduled for December 12 and the chance of a new referendum to vet the deal is escalating. According to Matt Gertken, BCA’s Geopolitical Strategist, an election does not increase the risk of a hard Brexit. Meanwhile, support for Brexit is near its lowest point since the June 2016 referendum (Chart I-3). Thus, a new plebiscite would not favor a “No Deal” Brexit. Sino-U.S. Trade War Chart I-4Why The Trade-War Ceasefire? The trade war truce will also greatly diminish economic uncertainty. Uncertainty created by the China-U.S. conflict accentuated the collapse in business confidence and capex intentions. The “phase one deal” announced earlier this month will likely materialize. The White House’s tactical retreat on trade is tied to U.S. President Donald Trump’s desire for a second term. He cannot risk inflicting further economic pain on his base of constituents.  Weekly earnings are decreasing for workers in swing states located in the industrial rust belt, especially in those areas that Trump carried in 2016 (Chart I-4). Those swing states are most affected by the slowdown in the global manufacturing and trade sectors. Beijing is also motivated to agree to truce due to its soft economy and deflationary pressures. An easing in trade uncertainty will be positive for the domestic economy. China’s willingness to replace Carrie Lam, the embattled Chief Executive of Hong Kong, and to withdraw the extradition bill at the heart of the protests confirms its eagerness to come to an agreement with the U.S. China’s readiness to make a deal is also made evident by its increasing imports of U.S. agricultural products (Chart I-4, bottom panel). Ultimately, the U.S. will not implement tariffs in December on $160 billion of Chinese shipments. Consequently, investors and businesses should become less concerned about the chances of a worsening trade war. Moreover, chances are growing of a decrease (but not a complete annulation) of the previously imposed U.S. tariffs on China. … And A Q1 2020 Acceleration In Global Growth Global economic activity will improve in Q1 2020 because the drag from China will dissipate and global liquidity conditions will improve. Many activity indicators increasingly reflect these fundamental supports. China China’s economy has reached a new low point: Q3 annual GDP growth is at a 27-year low of 6%, capital spending is weak, industrial production and profits show little life, the labor market is soft, and imports and exports continue to contract. However, a turn in policy has materialized, which will protect the domestic economy. Moreover, this summer’s Politburo and State Council statements showed an increased willingness to reflate the economy. The global economy will accelerate in Q1 2020. Credit creation has stabilized and monetary conditions have eased (Chart I-5). Faced with producer price inflation of -1.2% and employment PMIs of 47.3 and 48.2 in the manufacturing and non-manufacturing sectors, respectively, authorities have allowed the credit impulse to improve to 26% of GDP from a low of 23.8%. In accordance with this new policy direction, the drag from the shadow banking system’s contraction will slow considerably, thanks to a stabilization in both the growth rate of deposits of non-depository financial institutions and the issuance of bonds by small financial institutions. Additionally, the emission of local government bonds will accelerate. Beijing has also meaningfully eased fiscal policy, which is its preferred reflationary tool. Policymakers have cut taxes by 2.8% of GDP in the past two years. The marginal propensity of households to consume is trying to bottom (Chart I-5, bottom). If history is a guide, the acceleration in the rate of change of public-sector capex will fuel this turnaround in China’s marginal propensity to consume, and push up BCA’s China Activity Indicator (Chart I-6). Chart I-5Overlooked Chinese Improvements Chart I-6Public Investment Matters   Chart I-7A Bottom In Chinese Exports Growth? China’s economy is unlikely to bounce back as violently as in 2009, 2012 or 2016. Authorities are much more circumspect in their use of credit to reflate the economy than they were previously. Moreover, the regulatory environment will prevent a boom in the shadow banking system. Nonetheless, the fiscal push and the end of the decline in aggregate credit growth will allow the Chinese economy to stabilize and maybe pick up a bit. Therefore, China will move from a large headwind to a slight tailwind for global activity (Chart I-7, top panel). Mounting public capex also points toward a modest global recovery (Chart I-7, middle panel). Finally, the upturn in our Chinese reflation indicator, which incorporates both fiscal and monetary policy, points to a re-acceleration in U.S. capex intentions (Chart I-7, bottom panel). Global Liquidity Global liquidity conditions continue to improve and the global economy should soon respond within normal policy lags. 95% of central banks are loosening policy, which normally leads to an escalation in global activity (Chart I-8). The dominant central banks (the Federal Reserve, the European Central Bank and the Bank of Japan) will not tighten anytime soon. Inflation expectations in the U.S., the euro area and Japan stand at 1.9%, 1.1%, and 0.2%, respectively, well below levels consistent with a 2% inflation target. Moreover, U.S. core CPI has been perky, but both the ISM and the performance of transportation equities relative to utilities indicate that a deceleration in inflation is imminent (Chart I-9). Salaries are not yet inflationary either because U.S. real wages are growing in line with productivity (Chart I-9, bottom panel). In the euro area and Japan, realized core inflation remains at 1.0% and 0.5%, respectively, and supports the dovish message emanating from inflation expectations. Chart I-8Easier Global Policy Is Important Chart I-9If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief     Liquidity indicators are reflecting this accommodative policy setting. The growth of U.S. and European bank deposits has reaccelerated from 2.5% to 6%, a development linked to the exit of a soft patch (Chart I-10). Moreover, BCA’s U.S. Financial Liquidity Indicator is still moving higher and flashing a resurgence in the BCA Global Leading Economic Indicator (LEI), the ISM Manufacturing Index, commodity prices, and EM export prices (Chart I-11). Finally, U.S. and global excess money reinforce the message of BCA’s U.S. Financial liquidity Indicator (Chart I-12). Chart I-10Deposits Suggest The Worst Of The Slowdown Is Behind Us Chart I-11Continued Pick-Up In Financial Liquidity       The Fed will add to the supply of global liquidity by tackling the repo market’s seize-up. Depleting excess reserves and mounting financing needs among primary dealers resulted in the September surge in the Secured Overnight Financing Rate (SOFR). The Fed announced three weeks ago it would buy $60 billion per month of T-Bills and T-Notes, which will lead to a climbing stock of excess reserves. Higher excess reserves create a weaker dollar, stronger EM currencies and firming global PMIs (Chart I-13). Ultimately, EM currency strength eases EM financial conditions, which supports global growth (Chart I-13, bottom panel). Chart I-12Excess Liquidity Is Accelerating Chart I-13U.S. Excess Reserves Will Grow Again   Borrowing activity in Advanced Economies is showing signs of life. Bank credit is already responding to the drop in global yields, and global corporate bond issuance in September 2019 rose to $434 billion. In the U.S., new issues of corporate bonds have also reaccelerated (Chart I-14). Global Growth Indicators Crucial indicators of global economic activity are picking up on this improving fundamental backdrop. The list includes: A sharp takeoff in the annualized three-month rate of change of capital goods orders in the U.S., the Eurozone and Japan (Chart I-15, top panel). Improvement in this indicator precedes progress in the annual growth rate of orders and in capex itself. Chart I-14Borrowers Are Responding To Easier Financial Conditions Chart I-15Some Green Shoots Are Coming Through Chart I-16Positive Market Signals A significant upturn in the Philly Fed, Empire State, and Richmond Fed manufacturing surveys for October, which sends a positive signal for the ISM Manufacturing Index (Chart I-15, second panel). Moreover, the new orders and employment components of these surveys indicate that cyclical sectors of the economy will recover and the recent deterioration in employment conditions will be fleeting. A rebound in BCA’s EM economic diffusion index, which incorporates 23 variables. Such an increase usually precedes inflections in global industrial production (Chart I-15, bottom panel). An acceleration – both in absolute and relative terms - in the annual appreciation of Taiwanese stocks. A strong and outperforming Taiwanese equity market is a harbinger of firmer PMIs (Chart I-16, top two panels). A solid performance of EM carry trades financed in yen, European luxury equities, and the relative performance of global semiconductors, materials and industrial stocks, which signal stronger global PMIs (Chart I-16, bottom three panels). Bottom Line: The global economy will accelerate in Q1 2020. A melting probability of a “No-Deal” Brexit and a truce in the Sino-U.S. trade war will allow global uncertainty to recede. Concurrently, China’s economic slowdown is ending and global liquidity conditions are improving. The Dollar As The Arbiter Of Growth Chart I-17The Dollar Is A Counter-Cyclical Currency The dollar faces potent headwinds. The greenback is a countercyclical currency; a business cycle upswing and a weak USD go hand in hand (Chart I-17). The tightness of this relationship results from a powerful feedback loop: weak growth boosts the dollar, but the dollar’s strength foments additional economic slowdown. Global liquidity and activity indicators signal a weaker dollar because they point toward an economic recovery. BCA’s U.S. Financial Liquidity Index, which foresaw a deceleration in the greenback’s rate of appreciation, is calling for an outright depreciation (Chart I-18, top panel). The expanding holdings of securities on U.S. commercial banks’ balance sheets (a key measure of liquidity) corroborates this message. According to a model based on the U.S., Eurozone, Japanese and Chinese broad money supply, the USD should significantly depreciate in the coming 12 months (Chart I-18, third panel). Finally, our EM Economic Diffusion Index validates pressures on the greenback, especially against commodity currencies (Chart I-18, bottom two panels). Chart I-18Liquidity And Growth Indicators Point To A Weaker Dollar Growth differentials support this picture. Late last year, the stimulating effect of President Trump’s tax cuts allowed the U.S. to temporarily diverge from a weak global economy, but the U.S. manufacturing sector is now succumbing to the global slowdown. Once global growth snaps back, the U.S. is likely to lag behind as fiscal policy is becoming more stimulative outside the U.S. than in the U.S. Based on historical delays, this will continue to hurt the dollar (Chart I-19, top panel). Finally, the European economy generally outperforms the U.S. when China reflates, especially if Beijing’s push lifts the growth rate of M1 relative to M2, a proxy for China’s aggregate marginal propensity to consume (Chart I-20). Europe’s greater cyclicality reflects is larger exposure to both trade and manufacturing compared with the U.S. Chart I-19A Global Growth Convergence Will Hurt The Dollar Chart I-20European Growth To Rise Vis-A-Vis The U.S.   The greenback is expensive and technically vulnerable, which compounds its cyclical risk. The trade-weighted dollar is at a 25% premium to its purchasing power parity equilibrium (PPP), an overvaluation comparable to its 1985 and 2002 peaks. Moreover, our Composite Technical Indicator is overextended and has formed a negative divergence with the price of the dollar (see page 54, Section III). Finally, speculators are massively long the U.S. Dollar Index (DXY). Balance-of-payment flows also flash a significant downside in the dollar (Chart I-21). The U.S. current account deficit stands at 2.5% of GDP, but it is widening in response to the dollar’s overvaluation and the White House’s expansive fiscal policy. Since 2011, foreign direct investments (FDI) have been the main driver of the dollar’s gyrations. Last year, net FDI surged in response to profit repatriations encouraged by the Tax Cuts and Jobs Act of 2017, while portfolio flows stayed in neutral territory. This regulatory change had a one-off impact and FDI will begin to dry out. Therefore, financing the widening current account deficit will become harder. Finally, after years in the red, net portfolio flows into Europe have turned positive (Chart I-21, bottom panel). The USD’s depreciation will ease global financial conditions and supports growth further. In this context, interest rate differentials are noteworthy. The two-year spread in real rates between the U.S. and the rest of the G-10 has fallen significantly since October 2018. Reversals in real rates herald a weaker dollar, especially when it faces valuation, technical and flow handicaps. Moreover, European five-year forward short rate expectations are near record lows. If global growth can stabilize, then the five-year forward one-month OIS will pick up, especially relative to the U.S. An uptick will boost the EUR/USD pair and hurt the dollar (Chart I-22). Chart I-21Balance-Of-Payments Dynamics Turning Against The USD Chart I-22Relative Long-Term Rate Expectations And The Euro   The three most pro-cyclical currencies in the G-10 – the AUD, NZD and SEK - strengthen the most when BCA’s Global LEI bottoms but global inflation slows (Chart I-23). The GBP will likely generate a much stronger-than-normal performance next year. Cable trades at a 22% discount to PPP. It is also 19% cheap versus short-term interest rate parity models. The absence of a “No-Deal” Brexit should allow these risk premia to dissipate and the pound to recover. The CAD is also more attractive than Chart I-23 implies. The loonie is trading 10% below its PPP, and the USD/CAD often lags the EUR/CAD, a pair that has broken down (Chart I-24). Chart I-23Currency Performance As A Function Of Growth And Inflation Chart I-24EUR/CAD Flashing A Bearish USD/CAD Signal Bottom Line: A rebound in the global manufacturing sector next year will hurt the USD. The dollar is particularly vulnerable because growth differentials between the U.S. and the rest of the world have melted, the greenback is expensive, balance-of-payment dynamics are deteriorating and interest rate differentials are becoming less supportive. The USD’s depreciation will ease global financial conditions and supports growth further. Additional Investment Implications Bond Yields Have More Upside While the short-term outlook for bonds remains murky, the 12- to 18-month outlook is unambiguously bearish. The BCA Bond Valuation Index is still consistent with much higher U.S. yields in the next 12-18 months (see Section III, page 51). BCA’s Composite Technical Indicator for T-Notes is massively overbought and sentiment, as approximated by the Long-Term Interest Rates component of the ZEW survey, is overly bullish (Chart I-25). Thus, bonds represent an attractive cyclical sell. The Fed will not cut rates aggressively enough for bonds to ignore these valuation and technical risks. Treasurys have outperformed cash by 7.5% in the past year. Based on historical relationships, the Fed needs to cut rates to zero for bonds to beat cash in the coming 12 months (Chart I-26). After this week’s Fed cut to 1.75%, our base case is none to maybe one more rate cut. Chart I-25Sentiment Points To Yield Upside Chart I-26The Fed Must Cut To Zero For T-Notes To Outperform Cash Further   Bond yields will need a recession to move lower. The deviation of 10-year Treasury yields from their two-year moving average closely tracks the Swedish Economic Diffusion Index (Chart I-27, top panel). Sweden, a small, open economy highly levered to the global industrial cycle, is a good gauge of the global business cycle. The broad weakness in the Swedish economy is unlikely to worsen unless the global slowdown morphs into a deep recession. Even if global growth remains mediocre, Sweden’s Economic Diffusion Index will rise along with yields. The expansion in securities holdings of U.S. commercial banks and the stabilization in China’s credit flows both support this notion (Chart I-27, bottom panel). Financial market developments also point to higher yields. Sectors that typically capture the momentum in the global economy are perking up. For example, bottoms in the annual performance of European luxury equities or Taiwanese stocks have preceded increases in yields (Chart I-28). Chart I-27Yields Have Upside Chart I-28Key Financial Market Signals For Yields   Stocks Will Outperform Bonds Our conviction is strengthening that equities will outperform bonds. The total return of the stock-to-bond ratio has upside. BCA’s Global Economic and Financial Diffusion Index has rallied sharply, which often precedes an ascent in the stock-to-bond ratio, both in the U.S. and globally (Chart I-29). Bonds are much more expensive than stocks, therefore, only a recession will allow stocks to underperform in the coming 12 to 18 months. The environment is positive for equities. BCA’s Monetary Indicator is very elevated and our Composite Sentiment Indicator shows little complacency toward stocks among investors (see Section III, page 47). Finally, the strength in the U.S. Financial Liquidity Indicator supports the S&P 500’s returns (Chart I-30). Chart I-29Cyclical Indicators Argue In Favor Of Stocks Over Bonds Chart I-30Liquidity Tailwind For The S&P 500   A few market developments are noteworthy. 55.6% of the S&P 500’s constituents have reported Q3 earnings, and 74% of those firms are beating estimates. Moreover, the market is generously rewarding firms with the largest positive earnings surprises. Additionally, the Value Line Geometric Index is forming a reverse head-and-shoulder pattern, while the relative performance of the Russell 2000 has formed a double bottom (Chart I-31). The environment also favors cyclicals relative to defensive equities. By lifting bond yields, stronger economic activity leads to a contraction in the multiples of defensives relative to cyclicals. The latter’s earnings expectations respond more positively to reviving economic activity, which creates an offset to climbing discount rates. As a result, cyclicals often outperform defensives when the stock-to-bond ratio increases, or after Taiwanese equities gain momentum (Chart I-32). Chart I-31Improving Equity Market Dynamics Chart I-32Favor Cyclicals Over Defensives   Compared to other equity markets, the U.S. faces the most challenges. Our model forecasts a 3% annual drop in the S&P 500’s operating earnings in June 2020, and the deviation of U.S. equities from their 200-day moving average has greatly diverged from net earnings revisions (Chart I-33). U.S. equities have already discounted a turnaround in earnings. Moreover, the S&P 500’s margins have downside, a topic covered by BCA’s Chief Equity Strategist Anastasios Avgeriou.4 Our Composite Margin Proxy, Operating Margins Diffusion Index and Corporate Pricing Power Indicator all remain weak (Chart I-34). Downward pressure on margins will limit how rapidly earnings respond when a rebound in global economic activity lifts revenues. Finally, the S&P 500 trades at a historically elevated forward P/E ratio of 18.4, the MSCI EAFE trade at a much more reasonable 14-times forward earnings. Chart I-33Headwinds For U.S. Stocks Chart I-34Headwinds For U.S. Margins   The tech sector will also weigh on the performance of U.S. equities relative to international stocks. Tech stocks represent 22.5% of the U.S. benchmark, compared with 9.7% for the euro area. Anastasios recently argued that software spending has remained surprisingly resilient despite the global economic slowdown; it will likely lag spending on machinery and structures when the cycle picks up.5 Consequently, tech earnings will lag other traditional cyclical sectors. Moreover, tech multiples will suffer when the dollar depreciates and bond yields rise (Chart I-35). As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to discount factors. Unaffected by those negatives, European equities will benefit most from the outperformance of stocks relative to bonds. A weak dollar will be the first positive for the common-currency returns of European equities. Valuations are the second tailwind. The risk premium for European equities is 300 basis points higher than for U.S. stocks. Moreover, U.S. margins will likely diminish relative to the Eurozone’s because of stronger unit labor costs in the U.S. Sector composition will also dictate the performance of European equities. Compared with the U.S., Europe is underweight tech and healthcare stocks, a defensive sector (Table I-1). Investors who favor Europe will also bet against these two sectors. Europe is a wager on the other cyclical sectors: materials, industrials, energy and financials. Chart I-35Tech P/Es Are At Risk Table I-1Europe Overweights The Correct Cyclicals   European financials are particularly attractive. Negative European yields are a major handicap for European financials, but this handicap is already reflected in their price. European banks trade at a price-to-book ratio of 0.6 versus 1.3 for the U.S. This discount should be narrowing, not widening. Yields are bottoming and European loan growth is contracting at a -2% annual rate relative to the U.S. versus -8.6% five years ago. Meanwhile, the annual rate of change of European deposits is in line with the U.S. The attraction of European banks comes from the outlook for their return on tangible equity. A model shows that three variables govern European banks’ ROE: German yields, Italian spreads and the momentum of the silver-to-gold ratio (SGR). German yields impact net interest margins, Italian spreads drive peripheral financial conditions and thus, loan generation in the European periphery, and the SGR tracks the global manufacturing cycle (silver has more industrial uses than gold, but is equally sensitive to real yields), which affects loan flows in the European core. This model logically tracks the performance of European banks and financials (Chart I-36). Our positive outlook on global growth and yields, along with the fall in Italian spreads, augurs well for cheap European financial equities and banks in particular. Commodities Our constructive stance on the global business cycle and yields, plus our negative view on the greenback, is consistent with higher industrial commodity prices. Copper looks particularly attractive. Speculators are aggressively selling the metal, whose price stands at an important technical juncture (Chart I-37). Chart I-36The Drivers Of RoE Point To Higher European Bank Stock Prices Chart I-37Cooper Is An Attractive Play On Global Growth   Chart I-38Favorable Technical Backdrop For Silver-To-Gold Ratio Finally, we have favored the SGR since late June. Silver is deeply oversold and under-owned relative to the yellow metal (Chart I-38). Consequently, silver’s greater industrial usage should be a potent tailwind for the SGR.6 Mathieu Savary Vice President The Bank Credit Analyst October 31, 2019 Next Report: November 22, 2019 - Outlook 2020   II. Back To The Nineteenth Century The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.7 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. The U.S.-China conflict will not lead to complete bifurcation of the global economy. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”8 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”9 Chart II-1Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.10 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart II-1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. In a multipolar world, the U.S. will not be able to exclude China from the global system. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart II-2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart II-2China’s Mean Reverting Narrative In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart II-3). Chart II-3The Beijing Consensus Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead To Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. Diagram II-1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram II-1Trade War In A Bipolar World However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.11 History teaches us that trade occurs even amongst rivals and during wartime. The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.12 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart II-4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart II-4The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart II-5). This is for three reasons: Chart II-5Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.13 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. Diagram II-2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram II-2Trade War In A Multipolar World Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.14 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts II-1 and II-4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”15 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”16 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”17 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.18 Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.19 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart II-6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart II-7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart II-6The Allies Traded With Germany ... Chart II-7… Right Up To WWI   Chart II-8Japan And U.S. Never Downshifted Trade A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart II-8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram II-2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart II-9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart II-9The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart II-10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart II-11). Chart II-10Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group III. Indicators And Reference Charts The S&P 500 is making marginally new all-time highs. Seasonality is becoming very favorable for stock prices. However, our U.S. profit model continues to point south and expanding multiples have already driven this year’s equity gains. The S&P 500 has therefore already priced in a significant improvement in profits. Further P/E expansion will be harder to come by with bond yields set to rise. Thus, until the dollar falls and creates another tailwind for profits, stocks will not be as strong as seasonality suggests and will only make marginal new highs. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Until global growth bottoms and boosts the earnings forecasts of our models, stock gains will stay limited. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. continues to improve. This same indicator has recently turned lower in Japan. Meanwhile, it is deteriorating further in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth has picked up around the world, and global central banks continue to conduct very dovish policies. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Also, our BCA Composite Valuation index is still improving. As a result, our Speculation Indicator is back in the neutral zone. 10-year Treasury yields continue to rise, but they remain very expensive. Moreover, both our Bond Valuation Index and our Composite Technical Indicators are still flashing high-conviction sell signals. If the strengthening of the Commodity Index Advance/Decline line results in higher natural resource prices, then, inflation breakevens will also climb meaningfully. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Weak global growth has been the key support for the dollar in recent months. On a PPP basis, the U.S. dollar remains extremely expensive. Additionally, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. Moreover, the U.S. current account deficit has begun to widen anew. This backdrop makes the dollar highly vulnerable to a rebound in global growth. In fact, a breakdown in the greenback will be the clearest signal yet that global growth is rebounding for good. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-23Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1   Please see The Bank Credit Analyst "September 2019," dated August 29, 2019, available at bca.bcaresearch.com 2   Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 3   Please see The Bank Credit Analyst "August 2019," dated July 25, 2019, available at bca.bcaresearch.com 4   Please see U.S. Equity Strategy Special Report "Peak Margins," dated October 7, 2019, available at uses.bcaresearch.com 5   Please see U.S. Equity Strategy Weekly Report "Follow The Profit Trail," dated October 15, 2019, available at uses.bcaresearch.com 6   Please see Foreign  Exchange Strategy Weekly Report "On Money Velocity, EUR/USD And Silver," dated October 11, 2019, available on fes.bcaresearch.com 7   Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 8   Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 9   See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).  10  The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 11   Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 12   We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own.  13   See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 14   Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 15   See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 16   Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 17   Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 18  Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia.  19  See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.