Asset Allocation

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 Growth Is Experiencing A Welcome Rebound Growth 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... Economic Indicators Do Not Lead The Markets... Economic 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 Depressed Performances Have Scope For Long-Term Upside ...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 The Credit 6-Month Impulse Should Briefly Rebound The 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 The Oil Price 6-Month Impulse Should Help Oil Importing Economies The 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 If The Sharpest Decline In Bond Yields Is Over, Cyclicals Could Outperform If 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 Long Sweden Versus Denmark = Long Financials And Industrials Versus Biotech Long Sweden Versus Denmark = Long Financials And Industrials Versus Biotech Overweight banks means overweight Spain (Chart I-8). Chart I-8Long Spain = Long Banks Long Spain = Long Banks Long 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 Long Norway = Long Oil And Gas Long Norway = Long Oil And Gas Chart I-10Long Ireland = Long Airlines Long Ireland = Long Airlines Long 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 Long FTSE250 Versus FTSE100 = Long Pound Long 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 US: Oil & Gas Vs. Telecom US: Oil & Gas Vs. Telecom Chart I-13Tin Tin Tin 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 Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Four Impulses, Three Mistakes Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II_8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators 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 Stocks Could Go Either Way Stocks 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 Risks To The Economy And Stocks Risks 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 Weaker Brexit Support = No Hard Brexit Support Weaker 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? Why The Trade-War Ceasefire? Why 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 Overlooked Chinese Improvements Overlooked Chinese Improvements Chart I-6Public Investment Matters Public Investment Matters Public Investment Matters   Chart I-7A Bottom In Chinese Exports Growth? A Bottom In Chinese Exports Growth? A 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 Easier Global Policy Is Important Easier Global Policy Is Important Chart I-9If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief If 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 Deposits Suggest The Worst Of The Slowdown Is Behind Us Deposits Suggest The Worst Of The Slowdown Is Behind Us Chart I-11Continued Pick-Up In Financial Liquidity Continued Pick-Up In Financial Liquidity Continued 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 Excess Liquidity Is Accelerating Excess Liquidity Is Accelerating Chart I-13U.S. Excess Reserves Will Grow Again U.S. Excess Reserves Will Grow Again U.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 Borrowers Are Responding To Easier Financial Conditions Borrowers Are Responding To Easier Financial Conditions Chart I-15Some Green Shoots Are Coming Through Some Green Shoots Are Coming Through Some Green Shoots Are Coming Through Chart I-16Positive Market Signals Positive Market Signals Positive 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 Is A Counter-Cyclical Currency The 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 Liquidity And Growth Indicators Point To A Weaker Dollar Liquidity 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 A Global Growth Convergence Will Hurt The Dollar A Global Growth Convergence Will Hurt The Dollar Chart I-20European Growth To Rise Vis-A-Vis The U.S. European Growth To Rise Vis-A-Vis The U.S. European 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 Balance-Of-Payments Dynamics Turning Against The USD Balance-Of-Payments Dynamics Turning Against The USD Chart I-22Relative Long-Term Rate Expectations And The Euro Relative Long-Term Rate Expectations And The Euro Relative 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 November 2019 November 2019 Chart I-24EUR/CAD Flashing A Bearish USD/CAD Signal EUR/CAD Flashing A Bearish USD/CAD Signal EUR/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 Sentiment Points To Yield Upside Sentiment Points To Yield Upside Chart I-26The Fed Must Cut To Zero For T-Notes To Outperform Cash Further The Fed Must Cut To Zero For T-Notes To Outperform Cash Further The 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 Yields Have Upside Yields Have Upside Chart I-28Key Financial Market Signals For Yields Key Financial Market Signals For Yields Key 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 Cyclical Indicators Argue In Favor Of Stocks Over Bonds Cyclical Indicators Argue In Favor Of Stocks Over Bonds Chart I-30Liquidity Tailwind For The S&P 500 Liquidity Tailwind For The S&P 500 Liquidity 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 Improving Equity Market Dynamics Improving Equity Market Dynamics Chart I-32Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Favor 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 Headwinds For U.S. Stocks Headwinds For U.S. Stocks Chart I-34Headwinds For U.S. Margins Headwinds For U.S. Margins Headwinds 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 Tech P/Es Are At Risk Tech P/Es Are At Risk Table I-1Europe Overweights The Correct Cyclicals November 2019 November 2019   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 The Drivers Of RoE Point To Higher European Bank Stock Prices The Drivers Of RoE Point To Higher European Bank Stock Prices Chart I-37Cooper Is An Attractive Play On Global Growth Cooper Is An Attractive Play On Global Growth Cooper Is An Attractive Play On Global Growth   Chart I-38Favorable Technical Backdrop For Silver-To-Gold Ratio Favorable Technical Backdrop For Silver-To-Gold Ratio Favorable 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 Imperial Overstretch Imperial 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 November 2019 November 2019 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 November 2019 November 2019 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 November 2019 November 2019 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 The World Is No Longer Bipolar The 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 Multipolarity Is Messy Multipolarity 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 November 2019 November 2019 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 ... November 2019 November 2019 Chart II-7… Right Up To WWI November 2019 November 2019   Chart II-8Japan And U.S. Never Downshifted Trade November 2019 November 2019 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 Is Behind Us The 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 Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? Is Europe Really This Incompetent? Is 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 U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-23Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global 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.

Highlights In this report, we build and present models designed to predict the odds of Chinese investable equity sector outperformance, based on a set of macroeconomic and equity market factors. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to help investors to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. We see this as strongly supportive of the potential returns to be earned from active top-down sector rotation within China’s investable market. Cyclical stocks are very depressed relative to defensives, and we would favor them versus defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Feature In our June 19 Special Report, we reviewed the predictability and cyclicality of equity sector earnings in China's investable & domestic markets, and examined the relevance of earnings in predicting relative sector performance over the past decade. We noted that a few sectors scored highly in terms of earnings predictability and the relevance of those earnings in predicting relative performance. But we also highlighted that most of China's equity sectors, in both the investable and domestic markets, either demonstrated earnings trends that were difficult to predict based on the trend in overall market earnings or exhibited relative performance that was difficult to explain based on the relative earnings profile. Our models are designed to predict equity sector relative performance using a series of macroeconomic and equity market factors. In short, our June report underscored that China’s equity sectors warranted a closer examination, with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. Today’s report examines this question in depth, focused on China’s investable equity market. We hope to extend our research to the A-share market in the near future. Our approach focuses on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We conclude by highlighting the substantial underperformance of cyclical vs defensives sectors over the past two years, and argue that it is highly unlikely that cyclicals will underperform defensives over the coming 12 months if China strikes a trade deal with the US and the economy incrementally improves, as we expect. We also explain the importance of monitoring the relative performance of health care & utilities stocks over the coming few months, and present a unique sector-based barometer for gauging China’s reflationary stance. The latter two relative performance trends are likely to assist investors in positioning for the big call: the outperformance of Chinese investable stocks vs the global benchmark. Detailing Our Approach In our effort to better understand historical periods of sector outperformance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report1), and investors will often see it (in its conceptually different but practically similar probit form) employed when analyzing the likelihood of an economic recession. The New York Fed’s US recession model is a notable example of the latter,2 which has received much attention by market participants over the past year following the inversion of the US yield curve. The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). Charts I-1A and I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models Aimed At... This Report Builds Models Aimed At... This Report Builds Models Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts ...Predicting The Shaded Regions Of These Charts ...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Charts I-2A and I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... We Use These Macroeconomic And Equity Market Factors... We Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance ...To Predict Periods Of Equity Sector Outperformance ...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to 3 months in order to reduce the need to forecast. The link between tight monetary policy and industrial sector performance is one exception to this rule that we detail below. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, are detailed in Box 1. Box 1 Accounting For China’s 3½-Year Credit Cycle Over the course of the analysis detailed in this report, judgments concerning how much of a lead or lag to allow when accounting for any leading or lagging relationships between sector relative performance and either macroeconomic & stock market predictors were necessary. In cases where sector relative performance led any of our predictors, we capped the lead at 3-months to reduce the need to forecast the predictors when using the models. As explained below, the 8-month lead between industrial sector relative performance and tight monetary policy was the only exception to this rule. We also did not include any leading relationship between relative sector stock performance and the trend in relative sector EPS, and allowed at most a co-incident relationship. Limits were also required in the cases where our predictors led relative sector performance. While more lead time is usually better from the perspective of investment strategy, Chart I-B1 presents strong evidence of a 3½ -year credit cycle in China. Chart I-B2 illustrates the problem with including significant lags between predictors and relative sector performance when economic cycles are short. The chart shows the lead/lag correlation profile of the stylized cycle shown in Chart I-B1, and highlights that lags greater than 12-14 months risk picking up the impact of the previous economic cycle. Given this, we have limited the extent to which our predictors can lead relative sector performance in our models, and in practice lead times are generally less than one year. Chart I-B1Over The Past Decade, China Has Experienced A 3½-Year Credit Cycle A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Chart I-B2With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle The Key Drivers Of Chinese Investable Equity Sectors Pages 12-23 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 12-23 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Rising core inflation in China is the most important signal of sector performance that emerged from our analysis. Chart I-3China’s Sectors Linked Strongly To Core Inflation, Monetary Policy, And Growth A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Chart I-3 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that rising core inflation in China is the most important signal of sector performance that emerged from our analysis, followed by tight monetary policy, rising economic activity, rising broad market stock prices, oversold technical conditions, and rising broad market earnings. Chart I-3 highlights two important points: If regarded through the lens of causality alone, the strong relationship between rising core inflation and sector performance is somewhat surprising: normally, pricing power is subordinate to revenue/sales/demand as the primary factor driving fundamental performance. However, given that inflation is a lagging economic variable, we suspect that the significance of inflation in our models actually reflects the middle phase of the economic cycle in which sectors tend to best exhibit meaningful out/underperformance. It is also a stronger predictor of periods of tight monetary policy in China than headline inflation.3 This is an encouraging result for investors, as it suggests good odds that future episodes of meaningful sector outperformance can be identified given a particular macro view. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. While Chinese equity sector performance can sometimes be idiosyncratic, we see this as strongly supportive of the idea that investors can earn positive excess returns by actively shifting between China’s equity sectors using a top-down approach. Turning to the specific results of our sector models, we present the following big-picture findings of our research: Defining China’s Cyclical & Defensive Sectors From a top-down perspective, the most important element of sector rotation typically involves shifting from defensive to cyclical stocks when economic activity is set to improve (and vice versa). In China, it is clear from the results of our models that the investable energy, materials, industrials, consumer discretionary, and information technology sectors are cyclical sectors. The relative performance of these sectors exhibits a positive relationship to pro-cyclical macro variables, or broad market trends. Following last year’s GICS changes, we also include the media & entertainment industry group (within the new communication services sector) in this list. Correspondingly, investable consumer staples, health care, financials, telecom services, utilities, and real estate are defensive sectors in China. Chart I-4Cyclical Stocks Are Bombed Out Versus Defensives Cyclical Stocks Are Bombed Out Versus Defensives Cyclical Stocks Are Bombed Out Versus Defensives Chart I-4 illustrates how these sectors have performed over the past decade by grouping them into equally-weighted cyclical and defensive stock price indexes, as well as the relative performance of cyclicals versus defensives. The chart makes it clear that cyclical stock performance is essentially as weak as it has ever been relative to defensives over the past decade, with the exception of a brief period in 2013. Panel 2 highlights that all of the underperformance of cyclicals over the past two years has been due to de-rating, rather than due to underperforming earnings. The Atypical Case Of Financials & Real Estate The fact that financial and real estate stocks are defensive in China is somewhat curious. In the case of financials, the abnormality is straightforward: most global equity portfolio managers would consider financials to be cyclical, and our work suggests that this is not true for the investable market. Our explanation for this apparent discrepancy is also straightforward: while small and medium banks in China have obviously grown in prominence over the past decade, large state-owned or state-affiliated commercial banks are still dominant in the provision of credit to China's old economy. In most cases China’s large banks lend to state-owned enterprises with implicit government guarantees, meaning that the earnings risk for Chinese banks has typically been lower than for the investable market in the aggregate. It remains to be seen whether this will remain true in a world where Chinese policymakers are keen to slow the pace at which China’s macro leverage ratio rises and to render the existing stock of debt more sustainable for the non-financial sector. Indeed, over a multi-year time horizon, the risk are not trivial that banks will be forced to recapitalize as a result of forced changes to loan terms (eg: significant increases in the amortization period of existing loans) or the recognition of sizeable loan losses, which would clearly increase the cyclicality of the Chinese investable financial sector. Chart I-5A Seeming Contradiction: Real Estate Is High-Beta, But Defensive A Seeming Contradiction: Real Estate Is High-Beta, But Defensive A Seeming Contradiction: Real Estate Is High-Beta, But Defensive On the real estate front, the anomaly is not that real estate stocks respond defensively to macroeconomic and stock market variables, it is that real estate stock prices are considerably more volatile than this defensive characterization would suggest. Globally (and especially in the US), real estate stocks are often viewed as bond proxies and thus are typically low-beta, but Chart I-5 shows that this is not the case in China. In our view, this issue is reconciled by the fact that Chinese investable real estate stocks are also highly positively linked to Chinese house price appreciation, with relative performance typically leading a pickup in house prices by up to 1 year. This strongly leading relationship has meant that real estate stocks have often outperformed the broad market as economic activity is slowing, in anticipation that policy easing will lead to an eventual recovery in house prices. Chart I-6Still Following The Defensive Playbook This Year Still Following The Defensive Playbook This Year Still Following The Defensive Playbook This Year In effect, investable real estate stocks are a high-beta sector that have acted counter-cyclically due to the historical interplay between economic activity, monetary policy, and the housing market. Real estate performance this year has not deviated from this playbook (Chart I-6), and so for now we are content to include real estate stocks in our defensive index. But similar to the case of financials, we can conceive of scenarios in which ongoing Chinese financial sector reform may change this relationship in the future. The Unique Monetary Policy Sensitivity Of Industrials And Consumer Staples Pages 14 and 16 highlight that industrials and consumer staples stocks have typically been sensitive to periods of tight monetary policy. In the case of industrials the relationship is negative, whereas consumer staples relative performance has been positively linked to these periods. In both cases, relative performance has led periods of tight monetary policy, significantly so in the case of industrials (by an average of 8 months). While the relative performance of banks, tech, and real estate stocks have also been linked to periods of tight monetary policy, industrials and consumer staples are the only sectors that have tended to lead these periods. Chart I-7Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity This is a revelatory finding, and in our view it is explained by divergences in corporate health and leverage for the two sectors. We reviewed Chinese corporate health in our August 28 Special Report,4 and noted that the food & beverage sub-industry was a clear (positive) outlier based on our corporate health monitors. In particular, Chart I-7 highlights that food & beverage corporate health is markedly better than that for machinery companies or for industrial firms in general, supporting the notion that high (low) leverage is impacting the relative performance of industrials (consumer staples). The Leading Nature Of Health Care & Utilities Health care and utilities exhibit similar key drivers of relative performance: in both cases, periods of rising economic activity, rising core inflation, and rising broad market stock prices are all negatively associated with performance. Health care and utilities relative performance also happens to lead all three of those predictors, by 1-3 months on average depending on the variable in question. Our modeling work highlights that these are the only sectors whose relative performance has led multiple factors, suggesting that health care & utilities stocks are particularly interesting market bellwethers to monitor. Core Inflation Matters More Than Headline, Except For Energy & Real Estate As highlighted in Chart I-3, rising core inflation has been a much more important signal about relative sector performance than headline inflation. Chart I-8In China, Food Prices (Not Energy) Account For Headline/Core Differences In China, Food Prices (Not Energy) Account For Headline/Core Differences In China, Food Prices (Not Energy) Account For Headline/Core Differences The two exceptions to this rule relate to the energy and real estate sectors, with the former positively linked to headline inflation and the latter negatively linked. In both cases, we suspect that the relationship is a behavioral rather than a fundamental one. For energy, while rising headline inflation in developed countries is usually associated with rising energy prices, this is not true in the case of China. Chart I-8 highlights that differences between headline and core inflation over the past decade have almost always been driven by rising food prices. This implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are not driven by rising fuel costs. In the case of real estate, investor expectations of eroding real disposable income and its impact on the housing market are likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Investment Conclusions Our work aimed at explaining historical periods of Chinese investable sector outperformance has three investment implications in the current environment. Cyclicals will probably outperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. First, within China’s investable market, Chart I-4 illustrated that cyclical stocks are very depressed relative to defensives. Given our view that Chinese investable stocks are likely to outperform their global peers over a 6-12 month time horizon, we would also favor cyclicals to defensives over that period. For investors who are not yet overweight cyclical stocks in China, we would advise waiting for concrete signs that growth has bottomed (which should emerge sometime in Q1) before putting on a long position as we remain tactically neutral towards Chinese versus global stocks. But the key point is that it is highly unlikely that cyclicals will underperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Second, the fact that investable health care and utilities stocks have particularly leading properties suggests that they should be monitored closely over the coming few months. A technical breakdown in the relative performance of these sectors would be an important sign that market participants are anticipating a bottoming in China’s economy, which may give investors a green light to position for a bullish cyclical stance. For now, both of these sectors continue to outperform (Chart I-9), supporting our decision to remain tactically neutral towards Chinese stocks. Third, the heightened negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance trend between the two sectors may serve as a reflationary barometer for China’s economy. Chart I-10 shows that industrials outperformed staples last year once the PBOC shifted into easing mode, and anticipated the recovery in the pace of credit growth. However, industrials soon began to underperform staples, which also seems to have anticipated the fact that the recovery in credit was set to be less powerful than what has occurred during previous cycles. The fact that the relative performance trend is off its recent low is notable, and may suggest that China’s existing reflationary stance will be sufficient to stabilize economic activity if a trade deal with the US is indeed finalized in the near future. Chart I-9Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Chart I-10Industrials Vs. Staples Anticipated That Easing Would Only Be Measured Industrials Vs. Staples Anticipated That Easing Would Only Be Measured Industrials Vs. Staples Anticipated That Easing Would Only Be Measured As a final point, BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use the models as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We hope you will find these models to be a helpful quantification of the risk versus return prospects of allocating among China’s investable sectors. As always, we welcome any feedback that you may have about our approach.   Energy Chart II-1 Energy Energy Table II-1 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance   Unsurprisingly, our energy sector model highlights that periods of energy outperformance are strongly linked to periods of rising crude oil prices. However, what is surprising is that periods of accelerating headline inflation in China are even more closely linked to periods of energy sector outperformance than episodes of rising oil prices, and that these periods of accelerating inflation are not generally caused by rising energy prices. The lack of a clear economic rationale for this relationship implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are largely driven by rising food prices. The model also highlights that periods of strong undervaluation have historically been significant in predicting future energy sector outperformance, with a lag of roughly 8 months. The probability of energy sector outperformance has fallen sharply according to our model, but for now we continue to recommend a long absolute energy sector position on a 6-12 month time horizon. BCA’s Commodity & Energy Strategy service expects oil prices to trade at $70/barrel on average next year,5 Chinese headline inflation continues to rise, and we noted in our October 2 Weekly Report that energy stocks are heavily discounted.6 Barring a durable decline in oil prices below $55/barrel, investors should continue to favor China’s energy sector. Materials Chart II-2 Materials Materials Table II-2 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model highlights that the materials sector is one of the clearest plays on accelerating industrial activity within the investable universe. Among the macro variables that we tested, periods of investable materials outperformance are strongly positively linked with periods when our BCA Activity Index and our leading indicator for the index have been rising. Periods of materials sector outperformance have also been positively correlated with prior periods of oversold technical conditions and rising broad market stock prices, underscoring that materials are a strongly pro-cyclical sector. We currently maintain no active relative sector trades, but our model suggests that investors should be underweight the investable materials sector relative to the broad investable index. Industrials Chart II-3 Industrials Industrials Table II-3 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Periods of industrial sector outperformance have historically been positively correlated with relative industrial sector earnings, broad market stock prices, and prior oversold technical conditions. They have been negatively correlated with periods of tight monetary policy, rising core inflation, and prior overbought technical conditions. Since 2010, periods of industrial sector performance have led periods of tight monetary policy by 8 months, the longest lead of relative equity performance to any macro variable that we tested in our model (and the longest lead that we allowed). Industrial sector performance has also been strongly negatively linked with periods of rising core inflation. These findings, and the fact that our Activity Index and its leading indicator have not been highly successful at predicting periods of industrial sector outperformance, strongly suggest that industrials, while pro-cyclical, are primarily driven by expectations of easy monetary policy. We noted in an August 2018 Special Report that state-owned enterprises have become substantially leveraged over the past decade,7 and in a more recent report we highlighted that industries such as machinery have experienced a significant deterioration in corporate health over the past decade.8 This helps explain why industrial sector performance is so negatively impacted by tight policy. Our model suggests that the best time to be overweight industrial stocks is the early phase of an economic rebound, when Chinese stock prices are rising but market participants are not yet expecting tighter policy. These conditions may present themselves sometime in Q1, but probably not over the coming 0-3 months. Consumer Discretionary Ex-Internet & Direct Marketing Retail Chart II-4 Consumer Discretionary Ex-Internet & Direct Marketing Retail Consumer Discretionary Ex-Internet & Direct Marketing Retail Table II-4 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Besides materials, China’s investable consumer discretionary sector has historically been the most positively associated with coincident and leading measures of industrial activity. Rising core inflation is also highly positively related to consumer discretionary outperformance, which may reflect improved pricing power for the sector. The strong link with industrial activity is in contrast to depictions of China’s consumer sector as being less correlated to money & credit trends than the overall economy, and is supportive of our view that industrial activity forms one of the three pillars of China’s business cycle.9 We ended the estimation period of our model as of December 2018, in order to avoid including the distortive effects of last year’s changes to the global industry classification standard (which resulted in Alibaba’s inclusion and overwhelming representation in the investable consumer discretionary sector). As such, the results of our model apply today to consumer discretionary stocks ex-internet & direct marketing retail. For now, the absence of an uptrend in our Activity Index and in core inflation is signaling underperformance of discretionary stocks outside of internet & direct marketing retail. Outperformance this year largely reflects a significant advance in consumer durable and apparel: by contrast, automobiles & components have underperformed the broad market by roughly 14% year-to-date. Consumer Staples Chart II-5 Consumer Staples Consumer Staples Table II-5 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Historically, periods of consumer staples outperformance have been predicted by a falling Activity Index, periods of tight monetary policy, and over/undervalued conditions. The impact of monetary policy is particularly heavy in the model, suggesting that consumer staples are somewhat the mirror image of industrials in terms of the impact of leverage on relative equity performance. This too is supported by our August 28 Special Report,10 which noted that corporate health for the food & beverage sector was the strongest among the sectors we examined. However, the model failed to capture what has been very significant staples outperformance this year, highlighting the occasional limits of a rule-of-thumb approach to sector allocation. Investable consumer staples are reliably low-beta compared with the broad market, and we are not surprised that investors have strongly favored the sector this year amid enormous economic and policy uncertainty. An eventual improvement in economic activity, coupled with fairly rich valuation, should work against consumer staples stocks sometime in the first quarter of 2020. Investors who are positioned in favor of China-related assets should also be watching closely for any signs of a technical breakdown in the relative performance trend of investable staples. Health Care Chart II-6 Health Care Health Care Table II-6 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Among the macro variables tested in our model, periods of health care outperformance are negatively related to coincident and leading measures of industrial activity and strongly negatively related to rising core inflation.  Health care outperformance is also strongly negatively related to periods of rising broad market stock prices, and positively related to prior oversold technical conditions. These results clearly signify that investable health care is a defensive sector, to be owned when the economy is slowing and when investable stocks in general are trending lower. Our model suggests that health care stocks are likely to continue to outperform, as they have been since the beginning of the year. A substantive US/China trade deal that meaningfully reduces economic uncertainty remains the key risk to health care outperformance over a 6- to 12-month time horizon. Financials Chart II-7 Financials Financials Table II-7 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model highlights that periods of financial sector outperformance over the past decade have been negatively associated with periods of rising core inflation (a strong relationship), and with periods of rising index earnings. Oversold technical conditions have also helped explain future episodes of financial sector outperformance. The link between core inflation and the outperformance of financials appears to represent a behavioral rather than a fundamental relationship. When modeling periods of rising financial sector relative earnings, the trend in broad market EPS is more predictive than that of core inflation, highlighting that the latter’s explanatory power is due to investor behavior. The results of our model, and the fact that core inflation leads Chinese index earnings, suggests that financials are fundamentally counter-cyclical and that investors see rising Chinese core inflation as confirmation that an economic expansion is underway (and that broad market earnings are likely to rise). Our model is currently predicting financial sector outperformance, but investable financials have modestly underperformed since the beginning of the year. This appears to have been caused by the underperformance of financial sector earnings this year as overall index earnings growth has decelerated, contrary to what history would suggest. We suspect that the ongoing shadow banking crackdown is related to financial sector earnings underperformance, and we would advise against an overweight stance towards investable financials until signs of improving relative earnings emerge. Banks Chart II-8 Banks Banks Table II-8 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model shows that periods of banking sector outperformance are more linked to macro variables than has been the case for the overall financial sector. Specifically, bank performance is negatively correlated with leading indicators of economic activity and rising core inflation, and especially negatively correlated with periods of tight monetary policy. Banks have also typically outperformed following periods of oversold technical conditions. Similar to financials, bank earnings are typically counter-cyclical, but relative bank earnings have not been good predictors of relative bank performance over the past decade. Still, the negative association of relative stock prices with leading economic indicators, rising core inflation and rising interest rates underscores that investors should normally be underweight banks if they expect overall Chinese stock prices to rise. Also similar to the overall financial sector, our model is currently predicting outperformance for bank stocks, but investable banks have underperformed year-to-date. The shadow banking crackdown is also likely impacting investable bank earnings, leading to a similar recommendation to avoid bank stocks until relative earnings look to be trending higher. “Tech+”   Chart II-9 Tech+' Tech+' Table II-9 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our technology model has worked well at predicting periods of tech sector outperformance over the past several years, particularly from 2015 – 2017. The model suggests that, in addition to being negatively related to prior overbought conditions, periods of technology sector outperformance are associated with improving growth conditions, easy monetary policy, and rising prices. In other words, tech stocks are a growth & liquidity play. Owing to last year’s changes to the GICS, the results of our model apply today to Chinese investable internet & direct marketing retail, the media & entertainment industry group (within the new communication services sector), and the now considerably smaller information technology sector (the sum of which could be considered the “tech+” sector). The model has been predicting tech sector outperformance since May (in response to easier monetary policy), which has occurred for the official information technology sector. However, the BAT (Baidu, Alibaba, and Tencent) stocks are only up fractionally in relative terms from their late-May low. Our expectation that China’s economy is likely to bottom in Q1 means that we may recommend upgrading “tech+” stocks relative to the investable benchmark in the coming months. Telecom Services Chart II-10 Telecom Services Telecom Services Table II-10 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model for telecommunication services (now a level 2 industry group within the communication services sector) illustrates that telecom stocks have historically been counter-cyclical. Periods of telecom outperformance have been negatively associated with periods of rising core inflation, rising broad market stock prices, and rising broad market EPS. It is notable that telecom services stocks are driven more by cycles in overall stock prices than by cycles in economic activity. This suggests that investors tend to focus on the fact that telecom stocks are reliably low-beta compared with the overall investable market, causing out(under)performance of telecoms when the broad market is falling(rising). Similar to financials & banks, telecom stocks have not outperformed this year, in contrast to what our model would suggest. Earnings also appear to be the culprit, with the level of 12-month trailing earnings having fallen nearly 10% since the summer. China Mobile accounts for a sizeable portion of the telecom services index, and the company’s recent earnings weakness seems to be due to depreciation charges stemming from forced investment on 5G spending (mandated by the Chinese government). Our sense is that this will have only a temporary effect on telecom services EPS, meaning that investors should continue to expect the sector to behave in a counter-cyclical fashion over the coming year. Utilities Chart II-11 Utilities Utilities Table II-11 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance The early performance of our utilities model was mixed, as it generated several false sell signals during the 2011 – 2013 period despite recommending, on average, an overweight stance. However, over the past five years, the model has performed extremely well in terms of explaining periods of relative utilities performance. The model highlights that utilities are straightforwardly counter-cyclical. The relative performance of utilities stocks is positively related to its relative earnings trend, and negatively related to economic activity, rising core inflation, and broad market stock prices.  Consistent with a decline in the overall MSCI China index, the model has correctly predicted utilities outperformance this year. We expect utilities to underperform over a 6-12 month time horizon, but would advise against an aggressive underweight position until hard evidence of a bottom in Chinese economic activity emerges. Real Estate Chart II-12 Real Estate Real Estate Table II-12 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model for the relative performance of investable real estate has been among the most successful of those detailed in this report, which is somewhat surprising given the macro factors that the model shows drive real estate performance. While periods of relative real estate performance are modestly (negatively) associated with periods of tight monetary policy, rising headline inflation is the most important macro predictor of real estate underperformance. Among market factors driving performance, real estate stocks reliably underperform when broad market EPS are trending higher, and they historically outperform for a time after becoming relatively undervalued. Real estate relative performance is also strongly linked to periods of rising house prices, but the former tends to significantly lead the latter. Given that core inflation has better predicted episodes of tight monetary policy than headline inflation, investor expectations of eroding real disposable income is likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Beyond the negative link between higher inflation and interest rates on investable real estate performance, the strong negative association with broad market earnings underscores that investors treat real estate as a defensive sector. We thus expect real estate stocks to continue to outperform in the near term, but underperform over a 6-12 month time horizon.   Jonathan LaBerge, CFA Vice President jonathanl@bcaresearch.com   Footnotes 1. Please see China Investment Strategy, "Six Questions About Chinese Stocks," dated January 16, 2019. 2. Please see Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator at https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3. This is despite frequent concerns among investors that the PBOC is inclined to tighten in response to detrimental supply shocks. 4. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 5. Please see Commodity & Energy Strategy, "Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth," dated October 17, 2019. 6. Please see China Investment Strategy, "China Macro & Market Review," dated October 2, 2019. 7. Please see China Investment Strategy, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 8. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 9. Please see China Investment Strategy, "The Three Pillars Of China’s Economy," dated May 16, 2018. 10. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. Cyclical Investment Stance Equity Sector Recommendations

Highlights Rising recession risk, shaky economic fundamentals, and absence of positive yielding assets motivate us to reexamine which assets can be counted on to protect a portfolio in the future. We analyze 10 safe havens on four different dimensions: consistency, versatility, efficiency, and costs. Using this framework, we examine the historical performance of each safe haven and provide an outlook on their likely effectiveness over the next decade. We conclude that U.S. TIPS and farmland should provide the best portfolio protection. Cash, U.S. Treasuries and gold are other good alternatives. Meanwhile, U.S. investment-grade bonds, global ex-U.S. bonds, silver, and currency futures are likely to be poor protection choices. Feature For most investors, capital preservation is the most important goal when managing money. However, how to go about it remains a difficult question.  Investing in safe havens can be painful during bull markets, as their returns are usually lower than those of equities. Moreover, economic, political, and financial regimes change over time, which means that an asset that protected your portfolio in the past might not do so in the future. Therefore, it becomes good practice to review one’s safety measures periodically, even if one does not think that a crash is imminent. The current environment in particular, is a propitious time to review safe havens given that: Chart I-1A Great Time To Review Safety Measures A Great Time To Review Safety Measures A Great Time To Review Safety Measures A key recession signal is flashing red: The yield curve inverted in the United States in August (Chart I-1 – top panel). An inversion of the yield curve does not necessarily imply a recession, but historically it has been a very reliable signal of one, given that it indicates that monetary policy is too tight for the economy. Structural risks are rising: Rich equity valuations in the U.S. and high leverage levels elsewhere are signs that the pillars supporting this bull market might be fragile (Chart I-1 – middle panel). In addition, protectionism and populism, forces that BCA has long argued are here to stay, threaten to upend the regime of free trade that has benefited equities since the 1950s.1 Yields are near all-time lows: Historically, investors have been able to endure bear markets by hiding in safe assets with positive yield, as these assets will normally provide a reliable cash flow regardless of the economic situation. However, these type of assets are increasingly hard to find, particularly in the government bond space, where 50% of developed country bonds have negative yields (Chart I-1 – bottom panel). Considering these factors, how should investors protect their portfolios in the next decade? To answer this question, we analyze 10 safe havens divided into five broad asset classes: Nominal government bonds: U.S. Treasuries and global ex-U.S. government bonds. Other fixed income: U.S. investment-grade credit and U.S. TIPS.2 Currencies: yen futures and Swiss franc futures. Precious metals: gold futures and silver futures. Other assets: farmland and U.S. cash. We look at historical performance since 1973 for all safe havens except for global ex-U.S. bonds and farmland. For these assets, we look at performance since 1991 due to limited data availability. We mainly look at quarterly returns in order to compare illiquid assets to publicly traded ones. We do not consider each safe haven in isolation, but rather as an addition to equities within a portfolio. Specifically, we explore our safe haven universe relative to the MSCI All Country World equity index from the perspective of a U.S. investor. For our non-U.S. clients, we will release a report from the perspective of other countries if there is sufficient interest. Importantly, we do not look only at historical performance. We also examine whether there is a reason to believe that future returns will be different from past ones, by analyzing how the properties of each safe haven might have changed. When evaluating each safe haven, we focus on four properties: Consistency: a safe haven should generate consistent positive returns during periods of negative equity performance, with returns increasing with the severity of the equity drawdown. Versatility: safe havens should perform well across different types of crises. Efficiency: a safe haven should produce enough upside during crises, so only a small allocation to the safe haven is necessary to reduce losses. Costs: drag to portfolio overall performance (opportunity costs) should be as small as possible. Readers who wish to see just our overall conclusions should read our Summary Of Results section below. For our analysis of how safe havens have performed in the past, please see the Historical Performance section. Finally, for our analysis of how we expect the performance of safe havens to change, please see our Outlook section. Summary Of Results The Best Safe Havens U.S. TIPS should be an excellent safe haven to protect a portfolio in the next decade. While TIPS might not be as cheap to hold as they have been in the past, upside potential remains strong, which means that a moderate allocation can provide substantial protection to an equity portfolio. Moreover, U.S. TIPS are one of the best hedges against crises triggered by rising rates and inflation, which in our view are the biggest structural risks that asset allocators face. Farmland could also be a great safe haven for investors who have the ability to allocate to illiquid assets given that it is the cheapest safe haven in terms of portfolio drag. However, investors should be aware that the current low yield could potentially affect its performance during crises. Good Alternatives Cash can be a good alternative to protect an equity portfolio, given its outstanding performance during equity drawdowns caused by inflation. Moreover, its opportunity costs should decrease relative to the past. However, investors should take into account that the efficiency of cash at the current juncture is poor, which means that a relatively large allocation is needed in order to achieve meaningful portfolio protection. A portfolio with a 30% allocation to Treasuries historically provided the same downside protection as a portfolio with a 44% allocation to gold. We also like gold futures as a safe haven since they offer some of the most attractive opportunity costs. In addition, their upside is greater than that of most safe havens due to their negative correlations with real rates. However, gold’s volatility makes it an unreliable asset, which prevents us from placing it higher in the safe haven hierarchy. Historically, U.S. Treasuries have been one of the best safe havens to hedge an equity portfolio. Will this performance continue in the future? We do not think so. While yields are still high enough to provide plenty of upside potential, they have fallen to the point where they have increased the opportunity costs of U.S. Treasuries and reduced their consistency. The Rest Global ex-U.S. bonds have very limited upside due to their low yields. Meanwhile U.S. investment-grade credit remains at risk from poor corporate balance sheets, compounded by the fact that credit no longer has an attractive yield cushion. Currencies like the yen and the Swiss franc will continue to be unreliable and very expensive safe havens. Finally, while silver’s costs and reliability could improve, its high cyclicality relative to other safe havens will make silver a poor protection choice. Historical performance Consistency How did safe havens perform when equities lost money? To assess consistency, we plot the performance of each safe haven during all quarters when global equities had losses (Chart I-2). Cash and farmland were the only assets to have positive returns during every equity drawdown. U.S. Treasuries and U.S. TIPS were also very consistent, and had the additional advantage that their returns tended to increase as equity losses worsened. Global ex-U.S. bonds, while not as consistent, generated positive returns most of the time. Chart I-2Safe Haven Returns During Drawdowns In Global Equities Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s On the other hand, investment-grade bonds, the yen, the Swiss franc, gold, and silver were much more inconsistent. In general, even though these assets had larger positive returns than other assets, they were prone to deep selloffs concurrent with equity drawdowns. Silver was the worst of all safe havens, being mostly a negative return asset during quarters of negative equity performance. Versatility How did the type of crisis affect the performance of safe havens? We classify crises according to their catalyst into the following four categories: bursts of U.S. asset bubbles (tech bubble, 2008 housing crisis), ex-U.S. crises (1998 EM crisis, European debt crisis), flash crashes/political events (1987 Black Monday, 9/11 terrorist attack),  rate/inflation shocks (1974 oil crisis, 1980 Fed shock) and others (every other equity drawdown we could not classify).3  We look at the performance of seven safe havens since 1973 (Chart I-3A) and of all 10 since 19914 (Chart I-3B): Chart I-3ASafe Haven Return During Different Type Of Crisis (1973 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-3BSafe Haven Return During Different Type Of Crisis (1991 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s   During bursts of U.S. asset bubbles, U.S. Treasuries were the most effective hedge in both sample periods, followed by U.S. TIPS and farmland. Corporate bonds, cash, gold, and the Swiss franc also had positive returns, though they were small. Finally, the yen and silver had negative returns. During crises happening outside of the U.S., U.S. Treasuries were once again the best option. U.S. TIPS, yen futures, farmland, gold, and U.S. investment-grade bonds also provided strong returns.  Meanwhile, global ex-U.S. bonds and cash provided relatively weak returns, while both the Swiss franc and silver accrued losses. During flash crashes/political events, the Swiss franc had the best performance followed by global ex-U.S. bonds, though in general all safe havens but silver provided positive returns. Rate/inflation shocks were the most difficult type of crisis to hedge. Cash and U.S. TIPS were by far the best performers. Moreover, while U.S. Treasuries were able to eke out a small positive return, all other safe havens lost money during these crises. Efficiency How much allocation to each safe haven was needed to protect an equity portfolio? Chart I-4 show how adding incremental amounts of each safe haven5 to an equity portfolio reduced the overall portfolio’s 10% conditional VaR (the average of the bottom decile of returns).6 Since 1973, U.S. TIPS and U.S. nominal government bonds were the most efficient safe havens, providing the most protection per unit of allocation (Chart I-4 – top panel). Conditional VaR was reduced by almost half when allocating 40% to either Treasuries or TIPS. Cash, U.S. investment-grade, the yen, the Swiss franc, gold, and silver followed in that order. The difference between the safe havens was significant. As an example, a portfolio with a 30% allocation to U.S. Treasuries historically provided the same downside protection as a portfolio with a 36% allocation to U.S. IG credit, a 39% allocation to the yen or a 44% allocation to gold. Meanwhile, there was no allocation to silver which would have provided the same level of protection. When using a sample from 1991, the main difference was the reduced efficiency of cash – the result of lower average interest rates when using a more recent sample. Other than cash, the efficiency of most safe havens remained unchanged: U.S. Treasuries were the best option, followed by U.S. TIPS, farmland, U.S. investment-grade bonds, global ex-U.S. government bonds, cash, the yen, gold, the Swiss franc, and silver in that order (Chart I-4 – bottom panel). Chart I-4Historically, Fixed-Income Assets Were The Most Efficient Safe Havens Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Costs How do safe haven returns compare to equities? To evaluate opportunity costs, we compare the difference of the historical return of each safe haven versus global equities. Overall, hedging with currencies was extremely costly, as their return was well below that of equities in both samples (Chart I-5). Cash was also an expensive safe haven to hedge with, particularly in the most recent sample. On the other hand, fixed-income assets like U.S Treasuries, investment-grade credit, and U.S. TIPS had very low costs (global ex-U.S. bonds also had cost of around 2% in a limited sample).  Farmland had negative opportunity costs because it outperformed equities during the sample period.7 Chart I-5Historically Fixed Income Assets And Farmland Had The Lowest Opportunity Cost Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Outlook Chart I-6No More Yield Cushion Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-7Silver Has Become Less Cyclical Silver Has Become Less Cyclical Silver Has Become Less Cyclical For our outlook, we assess how the four traits under study have changed for all safe havens: Consistency: Will safe havens continue to be reliable in the absence of high coupons? Many of the safe havens in our sample were effective at hedging equities due to their high yield. Even if they had negative capital appreciation, total returns stayed positive thanks to the offsetting effect of the yield return. However, as rates have declined, yield return has also decreased substantially (Chart I-6). Therefore, safe havens, like cash, government bonds, and even farmland will not be as consistent as they were in the past. Credit could be even more vulnerable: the combination of a low yield, and unhealthy fundamentals will turn U.S. corporate bonds into a negative-return asset in the next crisis. Silver might be the lone safe haven to improve its consistency. Industrial use for silver has fallen substantially in the past 10 years, decreasing its cyclical nature (Chart I-7). Thus, while silver might still be an erratic safe haven, it should be more consistent in the future than its historical performance would suggest.   Versatility: What will the next crisis look like? Chart I-8Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Determining what the next crisis will look like is crucial for safe haven selection. Below we rank the types of crises in order of how likely and severe we think they will be in the future: Inflation/rate shock: We expect inflation to be significantly higher over the next decade. This will be the highest risk for asset allocators in the future. As we explained in our May 2019 report, a change in monetary policy framework, procyclical fiscal policy, waning Fed independence, declining globalization, and demographic forces are all conspiring to lift inflation in the next decade.8 Importantly, we believe that the Fed will be dovish initially, as it cannot let inflation continue to underperform its target after missing the mark for the last 10 years (Chart I-8 – top panel). However, this will cause an inflationary cycle, which will eventually lead the Fed to raise rates significantly and trigger a recession. Political events/flash crashes: Political events will also pose a risk to the markets on a structural basis. The rise of China as a superpower has shifted the world into a paradigm of multipolarity, which historically has resulted in military conflict. Moreover, animus for conflict is not dependent on President Trump. The American public in general feels that the economic relationship with China is detrimental to the United States (Chart I-8 – bottom panel). This means that any president, Democrat or Republican will have a political incentive to jostle with China for economic and political supremacy for years to come. Ex-U.S. crises: We expect Emerging Markets in general, and China in particular, to be among the most vulnerable parts of the global economy as we enter the next decade. Over the last 10 years, China’s money supply has increased four-fold, becoming larger than the money supply of the U.S. and the euro area combined. In addition, corporate debt as a % of GDP stands at 155%, higher than Japan at the peak of its bubble and higher than any country in recorded history (Chart I-9). We rank this type of crisis slightly below the first two because Emerging Market assets are depressed already. Thus, while we believe that there is further downside to come for these economies, some weakness has already been priced in. U.S. asset bubble burst: We believe that there are no systemic excesses in the U.S. economy, making a U.S. asset bubble burst a lesser risk than other types of crises. Although it is true that U.S. corporate debt stands at all-time highs, it is still at a much lower level than in other countries. Moreover, weakness of corporate credit is not likely to have systemic consequences on the economy, given that leveraged institutions like banks and households hold only a small amount of outstanding corporate debt (Chart I-10). Chart I-9EM crises Are Also A Risk EM crises Are Also A Risk EM crises Are Also A Risk Chart I-10A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences What does this ranking mean in terms of safe haven performance? U.S. TIPS and cash should be held in high regard as they will be some of the only assets that will perform well during an inflation/rate shock. The Swiss franc and global ex-U.S. bonds should be best performers during political crises, although U.S. TIPS could also provide adequate protection. Efficiency: Is there any upside left for safe havens when interest rates are near zero? As yields go below the zero bound it becomes harder for bonds to generate large positive returns. European or Japanese government bonds in particular would need their yields to go deep into negative territory to counteract a large selloff in equities (Table I-1). But can interest rates go that low? We do not think so. The recent auction of German bunds, where a 0%-yielding 30-year bond attracted the weakest demand since 2011, suggests that interest rates in these countries might be close to their lower bound.  On the other hand, though U.S. yields are low, they are still high enough for U.S. Treasuries to provide high returns in case of a crisis. Table I-1No Room For Positive Returns In The Government Bond Space Outside Of The U.S. Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Low rates also have an effect on the efficiency of U.S. investment-grade bonds, cash, and farmland because their upside during crises does not come from capital appreciation but rather from their yield, (the price of IG credit actually declines during most crisis). As mentioned earlier, their yield has declined substantially compared to the past, which means that a larger allocation will be necessary to counteract a selloff. Chart I-11Switzerland Has A High Incentive To Prevent The Franc From Appreciating Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s The upside of the yen could also be compromised. The Bank of Japan is likely to intervene aggressively in the currency market to prevent the Japanese economy from falling into a deflationary spiral, since it is very difficult for it to lower Japanese rates further. The Swiss franc is even more vulnerable. In contrast to Japan, Switzerland is a small open economy that has to import most of its products (Chart I-11). This means that the Swiss National Bank has a very high incentive to intervene in currency markets during a crisis, given that a rally in the franc could depress inflation severely. What about U.S. TIPS? In contrast to nominal government bond yields or even yields on corporate debt, U.S. real rates are not limited by the zero bound (Chart I-12).  This makes TIPS a more attractive option than other fixed-income assets, since real rates can have much more room for further downside than nominal ones. To be clear, this will only be the case if our forecast of an inflationary crisis materializes. Likewise, since gold is heavily influenced by real rates, it should also offer significant upside during the next crisis.9 Chart I-12Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Costs: Can I afford to hold safe havens in a world of low returns? To provide an outlook for the expected cost of each safe haven, we use the return assumptions from our June Special Report.10 We subtract the expected return on global equities from the expected return for each safe haven to reach an expected cost value. However, three of the safe havens (global ex-U.S. government bonds, the Swiss franc and silver) did not have a return estimate. We compute their expected returns as follows: For the Swiss franc we use the methodology we used for all other currencies in our report. We base the expected return on the current divergence from the IMF PPP value, as well as the IMF inflation estimates. In addition, we add the relative cash rate assumed return for both our yen and Swiss franc estimates, as futures take into account carry return. For global ex-U.S. bonds we take the weighted average of the expected return of the euro area, Japan, U.K., Canada, and Australia government bonds. We weight the returns according to their market capitalization in the Bloomberg/Barclays government bond index. Due to silver’s dual role as an inflation hedge and industrial metal, silver prices are a function of both gold prices and global growth. To obtain a return estimate we run a regression on silver against these two variables and use our growth and gold return estimate to arrive at an assumed return for silver. Chart I-13 shows our results: while their cost will improve, currency futures remain the most expensive hedge. The opportunity cost of precious metals and cash will decrease, making them more attractive options than in the past. Meanwhile, low yields will increase the opportunity costs of most fixed-income assets. Finally, farmland will remain the cheapest safe haven, even with decreased performance. Chart I-13Oportunity Cost For Fixed Income Safe Havens Will Be Higher Than In The Past Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Juan Manuel Correa Ossa Senior Analyst juanc@bcaresearch.com Appendix A Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Footnotes 1 Please see Geopolitical Strategy Special Report, "The Apex Of Globalization – All Downhill From Here, " dated November 12, 2014, available at gps.bcaresearch.com. 2 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 3 For a detailed list of how we classified each equity drawdown, please see Appendix A. 4 The only crises caused by a rate/inflation shock occurred in 1974 and 1980. Thus we have this type of drawdown only in Chart 3A and not in Chart 3B. 5 For yen, Swiss franc, silver and gold futures we assume an allocation to an ETF which follows their performance. Since futures have zero initial costs they cannot be directly compared to traditional assets in terms of percentage allocation. 6 We prefer this measure over VaR given that it captures the properties of the left tail of returns more accurately. 7  While the farmland index subtracts management fees, we recognize that there are costs involved in holding these illiquid assets which are not necessarily captured by the return indices. Thus, the real historical cost of holding farmland was not negative but likely close to zero. 8 Please see Global Asset Allocation Strategy Special Report "Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises," dated May 22, 2019, available at gaa.bcaresearch.com. 9 Please see Commodity & Energy Strategy Special Report "All that Glitters…And Then Some" dated July 25, 2019, available at ces.bcaresearch.com. 10 Please see Global Asset Allocation Strategy Special Report "Return Assumptions - Refreshed and Refined" dated June 25, 2019,  

Highlights Equities & Bonds: The accelerating upward momentum of global equities – the ultimate “leading economic indicator” – suggests that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. U.S. Agency MBS: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Feature The U.S. Federal Reserve and European Central Bank (ECB) are both set to ease monetary policy this week. The Fed is almost certain to deliver a third consecutive 25bp rate cut at tomorrow’s FOMC meeting, while the ECB will restart its bond buying program on Friday. Yet government bond yields around the world continue to drift higher, as markets reduce expectations of incremental rate cuts moving forward. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. Chart of the WeekMore Upside For Global Bond Yields More Upside For Global Bond Yields More Upside For Global Bond Yields Yields are finally responding to the evidence that global growth is troughing - a dynamic that we have been telegraphing in recent weeks. Global equity markets are rallying, with the U.S. S&P 500 hitting a new all-time high yesterday. The year-over-year increase in global equities, using the MSCI World Index, is now at +10%, the fastest pace of upward acceleration seen since January 2017. Some of that rally in U.S. stock markets can be chalked up to 3rd quarter earnings beating depressed expectations. Yet there is also a forward-looking component of the rally that bond markets are starting to notice. Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. Thus, equity prices should be considered a leading indicator of bond yields. We see no reason to discount the positive message on growth from rallying equity markets, especially when confirmed by an improvement in our global leading economic indicator (LEI), led by the more cyclical emerging market (EM) countries (Chart of the Week). Falling stock prices in 2018 accurately heralded the global growth slowdown of 2019 which triggered the huge decline in bond yields. Why should rising stock prices not be interpreted in the same light, predicting better global growth – and higher bond yields – over the next 6-12 months? Multiple Signals Point To Higher Bond Yields The more optimistic message on growth is not only confined to developed market (DM) stock prices. EM equities and currencies have begun to perk up, with EM corporate credit spreads remaining stable, as well, mimicking the moves seen in U.S. credit markets. Bond volatility measures like the U.S. MOVE index of Treasury options are retreating to the lower levels implied by equity volatility indices like the U.S. VIX index, which is now just above the 2019 low (Chart 2). Markets are clearly pricing out some of the more negative tail-risk outcomes that prevailed through much of 2019. Some of that reduction in volatility can be attributed to the recent de-escalation of U.S.-China trade tensions and U.K. Brexit risks, both important developments that can help lift depressed global business confidence. A reduction in trade/political uncertainty should help fortify the transmission mechanism between easing global financial conditions and economic activity – an outcome that could extend the rise in yields given stretched bond-bullish duration positioning (Chart 3). Chart 2A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop A More Pro-Risk Global Market Backdrop Chart 3Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields Less Uncertainty = Higher Yields The improving global growth story remains the bigger factor pushing bond yields higher, though. While the manufacturing PMI data within the DM world remain weak, the downward momentum is starting to bottom out on a rate-of-change basis (Chart 4). The EM aggregate PMI index is showing even more improvement, sitting at 51 and above the year-ago level, helping confirm the pickup in EM equity market momentum (bottom panel). Importantly, if this is indeed the trough in the EM PMI, the index would have bottomed above the 2015 trough of 48.5. Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure.  Given the improvement seen in “Big Mo” for global equities and global LEIs and PMIs, we remain comfortable with our current below-benchmark stance on global interest rate duration exposure. How high could yields rise in the near term? Looking at yields on a country-by-country level, a reasonable initial target for yields would be a return to the medium-term trend as defined by the 200-day moving average (MA). For benchmark 10-year DM government yields, those targets are: U.S. Treasuries: the 200-day MA is 2.18%, +23bps above the current level German Bunds: the 200-day MA is -0.22%, +11bps above the current level U.K. Gilts: the 200-day MA is 0.89%, +17bps above the current level Japanese government bonds (JGBs): the 200-day MA is -0.10%, +2bps above the current level Canadian government bonds: the 200-day MA is 1.59%, -2bps below the current level Australian government bonds: the 200-day MA is 1.53%, +43bps above the current level Among those markets, the U.S. is likely to reach the level implied by the 200-day MA, led by the market pricing out the -53bps of rate cuts over the next twelve months discounted in the U.S. Overnight Index Swap curve (Chart 5) – a number that includes the likely -25bp cut tomorrow. A move beyond that 200-day MA may take longer to develop, as it would require markets to begin pricing in some reversal of the Fed’s “mid-cycle cuts” of 2019. That outcome would first require a pickup in TIPS breakevens. The Fed would not feel justified in risking a tightening of financial conditions by signaling rate hikes without the catalyst of higher inflation expectations. Chart 4EM Growth Leading The Way? EM Growth Leading The Way? EM Growth Leading The Way? Chart 5UST Yields Have More Upside UST Yields Have More Upside UST Yields Have More Upside German Bund yields are even closer to that 200-day MA than Treasuries but, as in the U.S., a sustained move beyond that level would require an increase in bombed-out inflation expectations, with the 10-year EUR CPI swap rate now sitting at only 1.05% (Chart 6). As for other markets, the likelihood of reaching, or breaching, the 200-day MA is more varied (Chart 7). Chart 6Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation Bund Yield Upside Limited By Inflation The move in the Canadian 10-year yield to just above its 200-day MA fits with Canada’s status as a “high-beta” bond market, as we discussed in last week’s report.1 Chart 7Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? Which Yields Will Test The 200-day MA? The Bank of Canada also meets this week and, while no change in policy is expected, the central bank will be publishing a new Monetary Policy Report that will update their current line of thinking about the Canadian economy and inflation. U.K. Gilts should easily blow through the 200-day MA if and when a final Brexit deal is signed, as the Bank of England remains highly reluctant to consider any policy easing even as political uncertainty weighs on economic growth. With the European Union now agreeing to an extension of the Brexit deadline to January 31, and with U.K. prime minister Boris Johnson now pursuing an early election in December, the political risk premium in Gilts will persist. Thus, Gilt yields will likely lag the move higher seen in higher-beta markets like the U.S. and Canada. JGBs remain the ultimate low-beta bond market with the Bank of Japan continuing to anchor the 10-yield around 0%, making Japan a good overweight candidate in an environment of rising global bond yields. Australian bond yields have the largest distance to the 200-day MA, but the Reserve Bank of Australia is giving little indication that it is ready to shift away from its dovish bias anytime soon, while inflation remains subdued. We do not expect a rapid jump in yields back towards the medium-term trend in the near term, and Australian yields will continue to lag the pace of the uptrend in the higher-beta global bond markets. Net-net, a climb in yields over the next 3-6 months to (or beyond) the 200-day MA is most likely in the U.S. and Canada, and least likely in Japan, Germany and Australia (and the U.K. until the Brexit uncertainty is finally sorted out). Bottom Line: The accelerating momentum of global equities – the ultimate “leading economic indicator” – is suggesting that the current rise in global bond yields can continue. Maintain below-benchmark overall duration exposure, while staying overweight global corporate credit versus government bonds. Raise Allocations To U.S. Agency MBS Out Of Higher Quality Corporate Credit Chart 8U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates U.S. MBS More Attractive Than High-Rated U.S. Corporates Our colleagues at our sister service, BCA Research U.S. Bond Strategy, recently initiated a recommendation to favor U.S. agency MBS versus high-rated (Aaa, Aa, A) U.S. corporate bonds.2 This week, we are adding this position to the BCA Research Global Fixed Income Strategy recommended model bond portfolio. There are three factors supporting this recommendation: 1) The absolute level of MBS spreads is competitive The average option-adjusted spread (OAS) for conventional 30-year U.S. agency MBS – rated Aaa and with the backing of U.S. government housing agencies - is currently 57bps. That is only 3bps below the spread on Aa-rated corporates and 26bps below that of A-rated credit. (Chart 8). 2) Risk-adjusted MBS spreads look very attractive Agency MBS exhibit negative convexity, with an interest rate duration that declines when yields fall. The opposite is true for positively convex investment grade corporate bonds, where the duration rises as yields decrease. This makes agency MBS look attractive on a risk-adjusted basis after the kind of big decline in bond yields seen in 2019. The average duration of the Bloomberg Barclays U.S. agency MBS index is now only 3.4 compared to 7.9 for an A-rated corporate bond. Both of those durations were around similar levels at the 2018 peak in U.S. bond yields, but now the gap between them is large. With those new durations, it would take a 17bp widening of the agency MBS spread for an investor to see losses versus duration-matched U.S. Treasuries, compared to only an 11bp widening of the A-rated corporate spread (bottom panel). This is a big change in the relative risk profile of agency MBS versus high-rated U.S. corporates compared to a year ago, making the former look relatively more attractive. That was not the case the last time agency MBS duration fell so sharply in 2015/16, since corporate bond spreads were widening (getting cheaper) at that time. Today, corporate bond spreads have been stable as corporate duration has increased and agency MBS duration has plunged, making risk-adjusted MBS spreads more attractive. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. Given our view that U.S. Treasury yields will continue to grind higher, favoring lower duration assets like agency MBS over higher duration investment grade corporates makes sense. 3) Macro risks are reduced Mortgage refinancing activity remains the biggest macro driver of MBS spreads, particularly in an environment when mortgage rates are falling and prepayments are accelerating. There was a pickup in refinancing activity over the past year as mortgage rates fell, but the increase has been small relative to similar-sized rate declines in the past (Chart 9). We interpret this as an indication that, after the sustained period of low mortgage rates seen in the decade since the Great Financial Crisis, most homeowners have already had an opportunity to refinance. In other words, the so-called “refi burnout“ is now quite high. Chart 9Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Muted Refi Activity Keeping Nominal U.S. MBS Spreads Low Beyond refinancing, the other macro risks for agency MBS are subdued. The credit quality of outstanding U.S. mortgages remains solid. The median credit (FICO) score for newly-issued mortgages remains high and stable near the post-2008 crisis highs, while mortgage lending standards have mostly been easing over that same period according to the Federal Reserve Senior Loan Officers Survey. In addition, U.S. housing activity remains solid, with the most reliable indicators like single-family new home sales and the National Association of Home Builders activity surveys all up solidly following this year’s sharp drop in mortgage rates (Chart 10). This makes MBS less risky for two reasons: a) stronger housing activity typically leads to higher mortgage rates, which limits future refi activity; and b) more robust housing demand will boost home prices, the value of the underlying collateral for MBS securities. Chart 10U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up U.S. Housing Activity Hooking Up Chart 11Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Relative Value Favoring U.S. MBS Over U.S. Corporates Given the improved risk-reward balance of agency MBS versus higher-quality U.S. corporates, we recommend that dedicated fixed income investors make this shift within bond portfolios, reducing allocations to Aaa-rated, Aa-rated and A-rated corporates while increasing exposure to agency MBS. Agency MBS is part of the investment universe of our model bond portfolio. Thus, we are increasing the recommended weighting of agency MBS while reducing the exposure to U.S. investment grade corporates in the portfolio. The changes can be seen in the table on Page 11. We do not split out the investment grade exposure by credit tier in the portfolio, as we prefer to allocate by broad sector groupings (Financials, Industrials, Utilities). So we cannot implement the precise “MBS for high-rated corporates” switch in the model portfolio. There is still a case for reducing overall investment grade exposure and adding to MBS weightings, however. The relative option-adjusted spread of agency MBS and investment grade corporates typically leads the relative excess returns (over duration-matched U.S. Treasuries) between the two by around one year (Chart 11). Thus, the compression of the spread differential between MBS and corporates over the past year is signaling that agency MBS should be expected to outperform the broad U.S. investment grade universe over the next twelve months. Bottom Line: U.S. agency MBS spreads are now attractive relative to high-quality U.S. corporate bonds, both in absolute terms and on a risk-adjusted basis. Increase allocations to agency MBS, while reducing exposure to Aaa-, Aa- and A-rated U.S. corporates. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “Cracks Are Forming In The Bond-Bullish Narrative”, dated October 23, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresarch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Big Mo(mentum) Is Turning Positive Big Mo(mentum) Is Turning Positive Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights On a tactical horizon, underweight bonds versus cash, especially those bonds with deeply negative yields… …and underweight bonds versus equities. On a strategic horizon, remain overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos. New recommendation: switch Japanese yen long exposure into Swedish krona long exposure. Fractal trade: long SEK/JPY. Feature Chart of the WeekSwiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Anybody who has dared to bet that JGB yields would rise has ended up being carried out of their job, feet first. Shorting Japanese government bonds (JGBs) is known as the widow maker trade. Over the past 20 years, any investment manager who has dared to bet that JGB yields would rise – whether starting from 2 percent, 1 percent, or even 0.5 percent – has ended up being carried out of their job in a box, feet first. Today, the Bank of Japan’s policy of ‘yield curve control’ means that JGB yields are constrained within a tight range around zero, limiting their immediate scope to break higher. The European equivalent of the widow maker trade has been to short Swiss government bonds. Just as with JGB’s during the past two decades, anybody who has dared to bet that Swiss government bond yields would rise – whether starting from 2 percent, 1 percent, or 0.5 percent – has been proved fatally wrong (Chart I-2). Chart I-2Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds That is, until this year, when Swiss government bond yields reached -1 percent. The Lower Bound To Bond Yields Is Around -1 Percent According to several senior central bankers who have spoken to us, the practical lower bound to the policy interest rate is -1 percent, because “-1 percent counterbalances the storage cost of holding physical cash and/or other stores of value”. They argue that if bank deposit rates were to fall much below -1 percent, it would be logical for bank depositors to flee wholesale into physical cash, and such a deposit flight would destroy the banking system.1 Still, couldn’t central banks just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or the rapidly growing ‘decentralised’ cryptocurrency asset-class. The common counterargument is that cryptocurrencies’ volatility makes them a poor store of value. But that is also true for gold: during a few months in 2013, gold lost one third of its value (Chart I-3). Yet who has ever argued that gold cannot be a store of value just because its price is volatile! Chart I-3Gold Is A Store Of Value ##br## Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility The practical lower bound to the policy interest rate is around -1 percent because the central bank policy rate establishes the banking system’s funding rate – for example, the Eonia rate in the euro area (Chart I-4). If the funding rate fell well below the rate that the banks were paying on deposits, the banking system would come under severe strain and ultimately go bust. The lower bound of the policy rate also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. Chart I-4The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate There is one important exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Bonds which would expect to see a currency redenomination gain – notably, German bunds – therefore carry an additional discount on their yields. But for bonds where no currency redenomination is possible, the practical lower bound to bond yields is around -1 percent. Overweight High Yielding Bonds Versus Low Yielding Bonds To state the obvious, the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (capital gain), while the possibility for a yield increase (capital loss) stays unlimited. This unattractive lack of upside combined with plenty of potential downside is called negative skew or negative asymmetry. It follows that, close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices also becomes asymmetric. In risk-off phases, the bond prices cannot rally; while in risk-on phases, bond prices can plummet. Making such bonds a ‘lose-lose’ proposition. Case in point: Swiss bond yields have found it difficult to go down this year, but very easy to go up (Chart of the Week). Because their yields were already so close to -1 percent, Swiss bond yields could not decline much during the bond market’s recent strong rally – meaning, Swiss bond prices were very low beta on the way up. But in the recent reversal, Swiss bond yields have risen much more than others – meaning, Swiss bond prices are high beta on the way down (Chart I-5).   Chart I-5Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Does this mean the widow maker trade can finally work? Yes, but only on a tactical horizon. For the full rationale, which we will not repeat here, please see Growth To Rebound In The Fourth Quarter, But Fade In 2020. However in summary, expect bond yields to edge modestly higher, and especially those yields that are deeply in negative territory. Also on a tactical horizon, prefer equities over bonds.  On a longer term horizon, a much safer way to play the asymmetric beta is to short low yielding bonds in relative terms. In other words, overweight high yielding bonds versus low yielding bonds.2 Close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices becomes asymmetric. Our strategic recommendation is to overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Since initiation five months ago, the recommendation at the 30-year maturity is already up by almost 7 percent. Nevertheless, it has a lot further to go (Chart I-6). Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos (Chart I-7 and Chart I-8), but the combined two bonds versus two bonds recommendation has better return to risk characteristics. Chart I-6Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Chart I-7Expect Yield Spread Convergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Chart I-8...And At 30-Year ##br##Maturities ...And At 30-Year Maturities ...And At 30-Year Maturities Switch Into The Swedish Krona   Bond yield spreads are also an important driver of currency moves. The currency corollary of overweighting high yielding versus low yielding bonds is to tilt towards low yielding currencies, because these are the currencies that have the most scope for substantial upside. Our favourite low yielding currency has been the Japanese yen, and this has worked very well. Since early 2018, the yen has been the strongest major currency, and is up 16 percent versus the euro. But our favourite currency is now changing to the Swedish krona, for three reasons: The SEK is depressed from a valuation perspective. For example, it is the only major currencies that is weaker than the GBP compared to before the Brexit vote in 2016 (Chart I-9). Chart I-9The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit Unlike other major central banks, the Riksbank is seeking to normalise the policy rate upwards. The SEK is technically oversold on its 130-day fractal dimension, signalling over-pessimism in the price (Chart I-10), while the JPY is showing the opposite tendency. Chart I-10The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move Bottom Line: switch Japanese yen long exposure into Swedish krona long exposure. Fractal Trading System* (Chart 1-11) As just discussed, this week's recommended trade is long SEK/JPY. Set the profit target at 1.5 percent with a symmetrical stop-loss. In other trades, long NZD/JPY has started off very well and long Spain versus Belgium achieved its 3.5 percent profit target, at which it was closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 NZD VS. JPY NZD VS. JPY 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 The cost of holding physical cash is the cost of its safe storage. 2 Please see the European Investment Strategy Weekly Report ‘Growth To Rebound In The Fourth Quarter, But Fade In 2020’, October 3, 2019 available at eis.bcaresearch.com. Fractal Trading Model Cyclical Recommendations Structural Recommendations Fractal Trades The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Pricing Out Some Expected Rate Cuts ... Pricing Out Some Expected Rate Cuts ... Chart 4… Across All Developed Markets ... Across All Developed Markets ... Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Global Growth Bottoming Out Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cracks Are Forming In The Bond-Bullish Narrative Cracks Are Forming In The Bond-Bullish Narrative Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index.      Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Is This It? Is This It? Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Three Bulletproof Signals... Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator ...Combined Into One Leading Equity Indicator ...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Nil Corporate Pricing Power Nil Corporate Pricing Power Table 2Industry Group Pricing Power Is This It? Is This It? Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Relative Gains Are Exhausted Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming Cracks Forming Cracks Forming Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Contracting Sales Contracting Sales Chart 7Margin Trouble Margin Trouble Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Heed The Labor Market's Message Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Potentially Lower Rates Are A Key Risk Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Resumed Uptrend Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Solid Demand... Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads  ...Supply Backdrop Is Boosting Crack Spreads  ...Supply Backdrop Is Boosting Crack Spreads  Chart 13Profit Hurdle Is Uncharacteristically Low Profit Hurdle Is Uncharacteristically Low Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

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

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