Developed Countries

Highlights Expect more volatility in the near-term. The roughly 45% odds of a total US policy reversal in the November election are higher than the market expects. A “Gray Swan” event in the election would be a tie in the Electoral College at 269 versus 269 votes. While Trump would win in this scenario, the process is arcane and the election’s legitimacy would be challenged. Feature Constraints suggest the Democratic Primary nomination will go to a moderate candidate, but only if Bernie Sanders falls short of a strong plurality (~40%) of the vote. Currently, Sanders has momentum, so the risk is that he wins just such a plurality. The world remains spellbound by the risk that the coronavirus outbreak in China will cause a substantial slowdown with knock-on effects. We maintain a cautious stance toward risk assets in the near term in order to get clarity that the virus is indeed being contained. Our latest analysis of the virus impact can be found here and here. Our analysis of the impact on Chinese politics and policy — and forthcoming economic stimulus — can be found here and here. Meanwhile we continue to focus on the US election cycle — which threatens additional volatility both in the immediate term and in Q4. An Electoral College Tie?!? Our expectation that President Trump is slightly favored to win the election hasn’t changed, but our quantitative election model continues to signal that the race is “too close to call.” Specifically it awards Trump with the narrowest possible Republican victory in November. It suggests the president will lose Maine, Michigan, and Pennsylvania, yet keep Wisconsin (Chart 1). Chart 1Our Quant Model Signals That The Race Is "Too Close To Call" The intriguing thing about this combination of states is that it would produce an Electoral College tie, with the Republicans and Democrats each winning 269 votes! While the model generally should not be read so literally — the correct reading is “too close to call” — nevertheless a tie combination is not far-fetched and therefore constitutes a “Gray Swan” risk for this year: a high impact event whose probability is not all that low. The demographic data that we use to project the size and composition of the American voting public in 2020 — provided by the Center for American Progress and a coalition of high-powered Washington think tanks — provides at least one specific election scenario in which such a tie would result. This is a scenario in which the voter turnout and party support rates remain the same as in 2016 yet the elevated 5.7% of votes that went to third party candidates that year reverts back to its historical mean of 1.7%, where it stood in the 2012 election (Chart 2).1 A repeat of the 2016 election with third-party mean-reversion is not implausible. In 2020, President Trump still has a relatively weak approval rating, while none of the Democratic candidates is particularly charismatic or inspiring for key voting groups like African-Americans. (Charisma or a special demographic advantage are factors that could increase Democratic turnout and support from Hillary Clinton’s 2016 levels.) This year’s contest is a “closed election” with an incumbent president running, while 2016 was an “open election” in which voters had greater ability or willingness to flirt with parties outside the Republican-Democratic duopoly. Democratic candidate Hillary Clinton polled as the least favorable candidate in history at that time, with the sole exception of her rival, Republican candidate Donald Trump. The economy was also soft. A symbolic or strategic vote for the Libertarian Party or Green Party seemed a better option for about 6% of voters. Trump would be re-elected in the event of a tie. How is the presidency decided in the event of a tie? The House of Representatives votes to choose the president, albeit with each state only getting one vote. Currently Republicans have a majority in more congressional state delegations than Democrats — even if Pennsylvania is allotted to the latter (Chart 3). As a result President Trump would be re-elected. Chart 2A Tie In The Electoral College Is A "Gray Swan" Risk Chart 3Trump Would Be Re-Elected In The Event Of A Tie Needless to say, the American public is not familiar with the details of the twelfth amendment governing this process and there would be much heartburn from the losing party. The Democrats would highlight the popular vote (which Trump is highly likely to lose in most scenarios) and the “unrepresentative” nature of both the Electoral College and the House voting procedure. Such complaints would be ineffectual but the outcome would trigger a “legitimacy crisis” that would weaken the government’s mandate and exacerbate the country’s extreme polarization. Partisanship and polarization would also shoot through the roof if extremely thin margins of victory resulted in contested election results. Indeed the outcome of the election may not be clear on November 3. The 2000 election, the last time prior to 2016 that the Electoral College and popular vote produced different results, is the obvious example. President George W. Bush won by carrying Florida with 537 votes, but only after the Supreme Court intervened to put a stop to the contested recounting process in the state. President Trump won the critical swing states of the 2016 election by larger margins than that, but they were still thin and his net negative approval rating suggests thin margins could occur again in 2020 (Chart 4). Democratic contender Al Gore did not concede the election till a month later — would populist candidates like President Trump or Senator Bernie Sanders concede their loss? What would they do if the voting system somehow malfunctioned? The reporting debacle at the Democratic Party’s Iowa Caucus this month should serve as a reminder that voting systems are vulnerable to flaws and failures. Chart 4Trump’s Thin Margins In Swing States Could Occur Again In 2020 Even more controversial and polarizing, the Electoral College could swing because of the rogue actions of individuals. There can be no confidence in any prediction of a 269-269 Electoral College tie because college members are not always legally bound to vote for the candidate who carried the state they represent. “Faithless electors” are those who vote according to conscience rather than the strict mandate of their state. There were seven faithless electors in 2016, five of whom defected from Clinton and two of whom defected from Trump. In an election with tight margins in the Electoral College, it is conceivable that half of the population could be deprived of its democratic rights by the actions of a few individuals. There is a justification for the independence of electors but the point is that if they swung the election the results would be illegitimate in the eyes of around half of the country. In sum, the US election is shaping up to be extremely close, which means that frictions in the electoral system are likely to emerge. Thin and contested vote margins — or constitutional yet “unrepresentative” solutions to disputes — may deprive the government of legitimacy in the eyes of many and prolong America’s crisis of polarization. While financial markets expect a clear answer on November 3, they may not get it. Uncertainty may go up instead of down. Extreme polarization also has negative effects like abrupt vacillations in national policy — see the Iraq War, the 2015 Iranian nuclear pact, and domestic issues like the debt ceiling and the Affordable Care Act. Polarization can produce a self-feeding spiral that harms institutions and reduces predictability over the long run. Bottom Line: Can the equity market rally through contested elections and crises of legitimacy? Yes. It may even cheer a hamstring government for a while. But prolonged uncertainty — or social instability — would weigh on business and consumer sentiment. Update On The Democratic Primary: The Lead-Up To Super Tuesday Chart 5Bloomberg May Supplant Biden As Pro-Establishment Front Runner With the ninth Democratic Party primary debate concluding, the race for the nomination has blown open. Our view has been that a centrist or moderate candidate is most likely to emerge as the nominee and that former Vice President Joe Biden’s true testing ground would be in the South: South Carolina and Super Tuesday. Biden’s performance in Iowa and New Hampshire — where he angrily called a voter a “lying, dog-faced, pony soldier” — has been disastrous. Opinion polls suggest that New York City Mayor Michael Bloomberg may supplant him as the pro-establishment front runner (Chart 5). Bloomberg, however, has only just entered the race and has just suffered a hit from the combined onslaught of all the candidates at the ninth debate in Las Vegas. We need to see the votes — not just the money — to assess whether he can replace Biden (not to mention South Bend Mayor Pete Buttigieg and Minnesota Senator Amy Klobuchar) as the leading moderate candidate. Super Tuesday is critical for Bloomberg as well as for the other candidates who qualify for delegates and stay in the race after the Nevada Caucus on February 22 and South Carolina primary on February 29. With the roughly 55% share of votes going to moderates, Vermont Senator Bernie Sanders is benefiting from the ability to monopolize the remaining 45% of the vote for himself. That is, if Elizabeth Warren keeps failing to qualify. The problem for him is that his support could end up getting capped at around 25-30%, based on his performance thus far in Iowa, New Hampshire, and polling in Nevada, which is very different from 2016 when he divided the vote with Hillary Clinton alone (Chart 6). Chart 6Sanders’s Share Could Get Capped At 25-30% The question is whether Sanders can beat Warren definitively and sustain the momentum — which is very strong at the moment (Chart 7). He has tapped into the anti-establishment vein of the populace that propelled Trump to the Republican nomination in 2016. Chart 7Can Sanders Sustain The Strong Momentum? Party elites will not be able to reject Sanders if he wins a commanding plurality of the vote. Sanders is, thus far in the polling, more competitive for the nomination than Bloomberg (Chart 8), and more competitive than any candidate other than Biden when head-to-head against Trump (Chart 9). This is a tailwind in an election in which voters prioritize beating Trump: the more capable of doing so, the more momentum, the more capable of doing so. Chart 8Sanders Is Thus Far More Competitive Than Bloomberg Chart 9Sanders Is More Competitive Than Other Dem Candidates Vs. Trump, Except Biden There won’t be much clarity on the nomination process till after Super Tuesday at earliest. What is clear is that while Sanders may win a plurality of delegates (Chart 10), the moderates will take the nomination if they can coalesce around a candidate in time (Chart 11). Chart 10Sanders Likely To Win A Plurality Of Delegates … Chart 11… Unless Moderates Coalesce Around One Candidate Chart 12Super Delegates Could Tip The Scales Against Sanders, But Risk Sowing Discord It matters whether Sanders wins a commanding plurality of the vote and the proportionately allocated “unpledged delegates” to the Democratic convention. We benchmark his performance at 40%+, keeping in mind the 43% of the popular vote for the nomination that Sanders won in 2016. If he can win this large of a share of the Democratic Party voters, and stay well ahead of his second-ranked competitor due to vote splitting, then it will be hard for the party elites and elders to reject him. The so-called automatic delegates or “super delegates” can join in the second round of voting at the Democratic National Convention, and they would hesitate about a Sanders nomination and would be numerous enough to tip the scales against him (Chart 12). But to do so they would have to send 40%+ of their voters home aggrieved, which would be undemocratic and un-strategic for the party as it would cause a split in July just when it needed to band together to try to beat Trump. Game theory can help to illuminate the constraints of the primary if Sanders fails to win a strong plurality.2 What follows is a simple demonstration to provide a framework for understanding the voting procedure of the Democratic primary elections as a whole, and specifically multiple rounds of voting at a contested convention. Let us assume that the Democratic Party can be divided into three roughly equally popular voting groups for the primary contest: E = The Establishment = Biden, Klobuchar R = Reformers = Buttigieg, Bloomberg A = Anti-Establishment = Sanders, Warren The preferences of the groups are as follows: Establishment: E, R, A. The establishment cannot tolerate losing power to left-wing populism. Reformers: R, E, A. The reformers believe the establishment is out of date but favor gradual change rather than revolution and would prefer the establishment over a radical candidate. Anti-Establishment: A, R, E. The anti-establishment would prefer a populist, but would accept a reformer, as long as he is not the establishment. If the front runner is Sanders, he will lose the first round of voting, as E + R > A. In the second round, if the choice is Biden, Biden will be rejected: R + A > E. Therefore a reformer wins. This is still the outcome if Biden is the front runner in the first round, since Biden would lose (R + A > E) but then his voters would have to help a reformer win (R + E > A). Or, if Bloomberg were put up in the second round instead of Biden, the reformer still would win since R + A > E. Only if Bloomberg began the first round as a front runner would the outcome change. The first round he would lose because E + A > R. And then in the second round Biden would win because E + R > A. In the above voting sequence, neither the establishment nor the reformist voters would have an incentive to vote strategically — both would vote straightforwardly — since both rank the anti-establishment as their least preferred option. Super Tuesday will be critical in seeing if Sanders’s trajectory points toward a strong plurality. Therefore if Sanders cannot get a large enough plurality to win outright — large enough to compel unpledged candidates to join his coalition to win a majority of delegates — then he becomes the victim of a rational decision making process that works against him. The foregoing is a simple demonstration of the way the voting procedure will hurt a weak front runner — and elect someone other than an anti-establishment candidate — if the primary is conceived of as a simple sequential voting procedure, or if it comes to a contested election. But it is still possible that we could have the nomination decided by Sanders outperforming and clinching a majority in the primary elections, or in a brokered deal in June. Or another candidate, a moderate, could become the front runner and clinch the nomination while other moderate candidates are winnowed. Bottom Line: The Sanders risk to the equity market is immediate because he could win a strong plurality of delegates that could then create a dynamic that enables him to clinch the nomination. But if he falls short of a strong plurality then a reformer or establishment Democrat is favored. Super Tuesday will be critical in seeing if his trajectory points toward such a strong plurality. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 See Robert Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, April 2018. 2 See Steven J. Brams, Game Theory And Politics (Dover, 2004).

Neutral It has been particularly difficult to distinguish a clear signal from noise lately with regard to the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages. The recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel). Bottom Line:  Remain on the sidelines on cyclicals versus defensives. For more details on the positive data on the cyclicals/defensives ratio please refer to this Monday’s Weekly Report.​​​​​​​

Highlights In case you missed it in real-time, please listen to a playback of this this quarter’s webcast ‘What Are The Most Attractive Investments In Europe?’ available at eis.bcaresearch.com. Growth is set to plunge in the first quarter, keeping bond yields depressed for the early part of 2020 at least. Stay structurally overweight equities versus bonds so long as bond yields stay around current or lower levels. A 10 basis points decline in the 10-year bond yield can offset a 2 percent decline in stock market profits. Underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – until growth and bond yields enter a convincing uptrend. A strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the 10-year bond yield has reached a sufficiently strong 6-month deceleration. Fractal trade: the strong outperformance of utilities versus oil and gas is technically stretched. Feature Chart I-1Forget Growth, It's All About Valuation ‘Global health scare takes world stock markets to new highs’ would make a jarring, provocative, and counterintuitive headline. But it would be true… at least so far. Most economists expect the global health scare emanating from China to depress economic growth. My colleague, Peter Berezin, forecasts global growth to drop to near zero during the first quarter. Yet the aggregate stock market seems largely unfazed. Most bourses are riding high, and in some cases not far from all-time highs. How can this be if the market is downgrading growth? Ultra-Low Bond Yields Are Protecting The Stock Market Although stock market profits are being revised down, the multiple paid for those profits is rising by more than the profits are falling. Stock market valuations have become hyper-sensitive (inversely) to ultra-low bond yields. Meaning that the valuation boost from a small decline in bond yields is more than sufficient to counter the growth drag from the coronavirus scare. This is not just a recent phenomenon. For the past two years, a good motto for investors has been: forget growth, it’s all about valuation (Chart of the Week). Through 2018-19, profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018, then surged in 2019 (Chart I-2 and Chart I-3). The reason was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing (long-duration) bonds. But crucially, at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. Chart I-2The Big Moves In The Stock Market... Chart I-3...Have Been About Valuation, Not Growth When bond yields approach their lower bound, bonds become extremely risky investments because the scope for price rises diminishes while the scope for price collapses increases. The upshot is that all (long-duration) investments become equally risky, and the much higher prospective returns required on formerly more risky equities collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, the valuation of equities becomes hyper-sensitive to small changes in bond yields. A 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.2 percent and then down to around 1.6 percent today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then up to around 17 today, a 30 percent increase. Which means that broadly speaking, a 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits (Chart I-4). Chart I-4The Bond Yield Is Driving The Stock Market's Valuation Therefore, as the coronavirus scare illustrates, the biggest structural threat to the aggregate stock market does not come from slowing growth so long as bond yields continue to adjust downwards. The biggest threat comes from an outsized increase in bond yields, stemming from a subsequent modest acceleration in either growth or inflation. But we do not expect this in the first half of the year (at least). Bond Yields To Stay Depressed For The First Half At Least Although the coronavirus scare is a convenient scapegoat for the growth downgrade, the scare has just amplified a growth deceleration that was going to happen anyway. As we explained at the start of the year in Strong Headwind Warrants Caution In H1, a growth deceleration in Europe and worldwide during early 2020 was already well baked in the cake. The 6-month acceleration in bond yields at the end of 2019 was among the sharpest in recent years. Growth decelerations stem neither from the level of bond yields nor from the change in bond yields (or financial conditions). Growth decelerations stem from the acceleration of bond yields. And the 6-month acceleration in bond yields at the end of 2019 – both in Europe and worldwide – was among the sharpest in recent years (Chart I-5). Chart I-5After A Sharp 6-Month Acceleration In Bond Yields, Yields Stay Depressed For The Following 6 Months Although the link between a bond yield acceleration and a GDP deceleration seems hard to grasp, it results from a basic accounting identify. GDP is a flow statistic. So if a credit flow contributes to GDP, it must be a credit flow deceleration that contributes to a GDP deceleration. And if the level of the bond yield establishes the size of a credit flow, it must be a bond yield acceleration that establishes the size of a credit flow deceleration (Chart I-6).  Chart I-6A Bond Yield Acceleration Causes A Credit Flow Deceleration Given the lags between bond yields impacting credit flows and credit flows impacting spending, a sharp 6-month acceleration in the bond yield – like the one experienced at the end of 2019 – tends to keep the bond yield depressed for the following six months. On this basis, we would not expect an outsized increase in the bond yield during the first half of this year. In fact, a continued decline in yields could eventually turn into a sharp 6-month deceleration in the bond yield, leading to an acceleration in credit flows and growth, and providing a forthcoming opportunity to become more pro-cyclical.  Big Winners And Losers Across Sectors, Regions, And Countries To repeat, the growth scare has not had a major impact on the aggregate stock market (so far) because the valuation boost from a small decline in bond yields is more than sufficient to counter the downgrade to profits. But the growth scare has had a major impact on sector, regional, and country winners and losers. Understandably, the sectors most exposed to the declining bond yield have performed very well. These fall under two categories: the first is bond proxies, meaning sectors that pay a stable bond-like income, such as utilities; the second is long-duration investments meaning sectors whose income is likely to grow rapidly, such as tech and healthcare. This is because the more distant is the future cash flow, the greater is the uplift to its ‘net present value’ for a given decline in the bond yield. The growth scare has had a major impact on sector, regional, and country winners and losers. Conversely, the sectors most exposed to short-term growth have performed poorly. These include banks and energy. Banks suffer also because declining bond yields erode their net interest (profit) margin (Chart I-7). In turn, the sector winners and losers have determined the regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. When energy underperforms, the energy-heavy Norway and UK stock markets must underperform. It also follows that the tech-heavy and healthcare-heavy US stock market must outperform (Chart I-8).  Chart I-7Sector Winners And ##br##Losers... Chart I-8...Explain Regional And Country Winners And Losers Some of the more extreme sector and country outperformances and underperformances are now technically stretched (see following section). Nevertheless, a general strategy to underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – will remain appropriate until growth and bond yields enter a convincing uptrend. To reiterate, one strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the bond yield has reached a sufficiently strong 6-month deceleration. Stay tuned. Fractal Trading System* The strong outperformance of utilities versus oil and gas is technically stretched, especially in the US, and a reversal is likely within the next three months. Short US utilities versus oil and gas, setting a profit target of 7.5 percent with a symmetrical stop-loss. In other trades, short Ireland versus Europe reached the end of its holding period having achieved half of its profit target. The rolling 1-year win ratio now stands at 59 percent. Chart I-9US: Utilities Vs. Oil And Gas 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. * 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 Fractal Trading Model Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The elevated uncertainty about global growth stemming from the COVID-19 virus in China has not only made investors more anxious, but central bankers as well. This means that, only six weeks into the year, policymakers may already be having to rethink their expected strategies for 2020 - which were, for the most part, sitting on hold after the monetary easing in 2019. This has important implications for the direction of global bond yields, which were starting to see a cyclical increase before the viral outbreak. In this report, we present what we see as the most important data for investors to focus on in the major developed markets to get the central bank call correct. This is based on our interpretation of recent speeches, press conferences and published research. We also provide our own suggested data series to watch for each country – which do not always line up with what central bankers are saying they are most worried about. We conclude that it is still not clear that the global growth backdrop has turned sustainably more bond bullish, but there is no pressure on any of the major central banks to move away from extremely accommodative policy settings. Feature Over the past four weeks, all of the major central banks have had the opportunity to formally communicate their current views to financial markets. Whether it was through post-policy- meeting press conferences or published monetary policy reports, central bankers have tried to signal their intentions about future changes in the direction of interest rates, given the heightened uncertainties about the momentum of global growth. At the moment, our global leading economic indicator (LEI) is still signaling that 2020 should see some rebound in global growth – and bond yields – after the sharp 2019 manufacturing-led slowdown (Chart 1). Unfortunately, the latest read on the global LEI uses data as of December, so it does not include what is almost certainly to be a very severe slowdown in the Chinese (and global) economy in the first quarter of 2020 due to the COVID-19 virus outbreak. Underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year.  Central bankers are in the same spot as investors, trying to ascertain the extent of the hit to global growth from the virus, both in terms of size and, more importantly, duration. This comes at a time when many central banks were already formally rethinking how to meet their own individual inflation-targeting mandates given the persistence of low global inflation alongside tight labor markets (Chart 2). Chart 1Global Bond Yields: Think Globally, Act Locally Chart 2Common Worries For All CBs: China & Global Inflation That all sounds potentially very bond-bullish, but a lot of bad economic news is already discounted in the current low level of global bond yields. More importantly, the underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year. In this Weekly Report, we provide a brief synopsis of what we believe are the biggest concerns for each of the major developed economy central banks. This is based on our read of recent policy decisions and central banker statements, as well as our own understanding of the current reaction function of policymakers. Our intention is to provide a short list of indicators to watch for each central bank, to help cut through the noise of data and news during this current period of unusual uncertainty, as well as our own assessment of what policymakers should be focusing on more. We conclude that it is still too soon to expect a new wave of bond-bullish global monetary policy easings in 2020. It will take evidence pointing to an extended shock to global growth from the COVID-19 virus to reverse the bond-bearish signal from other indicators like our global LEI. Federal Reserve Chart 3Federal Reserve: Focus On Financial Conditions & Inflation Expectations Currently, the Fed’s commentary suggests a policy bias that can be described as “neutral-to-dovish”, but it is giving no indication that additional rate cuts are likely in 2020 after the 75bps of cuts last year. Markets remain skeptical, however, with -42bps of cuts over the next twelve months now priced into the USD overnight index swap (OIS) curve according to our Fed Discounter (Chart 3). What the Fed seems most focused on: Fed officials seem focused on measures of market-based inflation expectations, like TIPS breakevens, as the best indication that current policy settings are appropriate (or not) relative to the growth outlook of investors. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019 (middle panel). Right now, with the 10-year TIPS breakeven at 1.67% and the 10-year/3-month US Treasury curve now at only -1bp, another decline in longer-term inflation expectations will likely invert the Treasury curve. What the Fed should be more focused on: US financial conditions are highly stimulative, with equity indices back near all-time highs and corporate credit spreads remaining well-contained at tight levels. Given the usual lead times of financial conditions indices to US cyclical growth indicators like the ISM manufacturing index (bottom panel), a continuation of the most recent bounce in the ISM is still the most likely result – even allowing for a near-term hit to global growth from China. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019. Bottom Line: The incoming US growth data is critical to determine the Fed’s next move. If there is no follow through from easy financial conditions into faster growth momentum, the odds increase that the Treasury curve will become more deeply inverted for a longer period of time – an outcome that would likely prompt more rate cuts, especially if equity and credit markets also begin to sell off as growth disappoints. European Central Bank Chart 4ECB: Focus On Manufacturing & Inflation Expectations The ECB has been clearly signaling that it still has a dovish bias, although central bank officials have acknowledged that the options available to them to ease further are limited with policy rates already in negative territory. The market agrees, as there are only -7bps of cuts over the next twelve months now priced into the EUR OIS curve according to our ECB Discounter (Chart 4). What the ECB seems most focused on: The ECB has been paying the most attention to the contractions in euro area manufacturing data (like PMIs) and exports seen in 2019. Rightly so, as nearly all of the two percentage point decline in year-over-year euro area real GDP growth since the late-2017 peak has come from weaker net exports. The central bank has also been concerned about the depressed level of inflation expectations, with the 5-year EUR CPI swap rate, 5-years forward, now at only 1.23% - far below the ECB’s inflation target of “at or just below” 2%. What the ECB should be more focused on: We agree that the focus for the ECB should be most concerned about the weakness in manufacturing/exports and low inflation expectations – the latter having not yet responded to extremely stimulative euro area financial conditions (most notably, the weak euro). The euro area economy is highly leveraged to Chinese demand, with exports to China representing 11% of total euro area exports. This makes leading indicators of Chinese economic activity, like the OECD China LEI and the China credit impulse, critically important indicators in determining the future path of European export demand. The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. Bottom Line: The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. If the China demand shock to euro area exports is large enough, the ECB will likely be forced to deliver a modest interest rate cut – or an expansion of the size of its monthly asset purchases – to try and boost growth. Bank Of England Chart 5Bank Of England: Focus On Business Sentiment & Labor Costs The Bank of England (BoE) has a well-deserved reputation as having an unpredictable policy bias under outgoing Governor Mark Carney, but the central bank does appear to be currently leaning on the moderately dovish side of neutral. Short-term interest rate markets also feel the same way, with -19ps of easing over the next twelve months priced into the GBP OIS curve according to our BoE Discounter (Chart 5). What the BoE seems most focused on: The BoE has been paying a lot of attention to indicators of UK business sentiment, which had been negatively impacted by both Brexit uncertainty and global trade tensions in 2019. The BoE has focused on the link from depressed business sentiment to weak investment spending and anemic productivity growth as an important reason why UK potential GDP growth has been so low and why UK inflation expectations have been relatively high. What the BoE should be more focused on: We agree that business sentiment should be the BoE’s greatest area of focus. Sentiment has shown a solid improvement of late, after the signing of the “phase one” US-China trade deal in December and the formal exit of the UK from the EU on January 31. The CBI Business Optimism survey (measuring the net balance of optimists versus pessimists) soared from -44 in October to +23 in January – the biggest quarterly jump ever recorded in the series. It remains to be seen if this improvement in confidence can be sustained and begin to arrest the steady decline in UK capital spending and productivity growth, and the associated surge in unit labor costs and inflation expectations, that has taken place since the 2016 Brexit vote. Bottom Line: The BoE’s next move, under the new leadership of incoming Governor Andrew Bailey, is not clear. Inflation expectations remain elevated but the recovery in business sentiment is still fragile. One potential risk to watch: UK Prime Minister Boris Johnson may choose to take a bolder stand on trade negotiations with the EU after his resounding election victory in December, risking an outcome closer to the “no-deal Brexit” scenario that was most feared by UK businesses. Bank Of Japan Chart 6Bank of Japan: Focus On Exports & The Yen The Bank of Japan (BoJ) seems to have had a perpetually dovish bias since the 1990s. Yet the current group of policymakers under Governor Haruhiko Kuroda, realizing that they have run out of realistic policy options after years of extreme stimulus, has not been signaling that fresh easing measures are on the horizon, even with economic growth and inflation remaining very weak in Japan. Markets have taken the hint, with only -6bps of rate cuts over the next twelve months priced into the JPY OIS curve according to our BoJ Discounter (Chart 6). What the BoJ seems most focused on: The BoJ has been vocally concerned about the recent slump in Japanese consumer spending, which declined -2.9% (in real terms) in Q4 after the sales tax hike last October. That blow to consumption was expected, but could not have come at a worse time for a central bank that was already worried about plunging Japanese manufacturing activity and exports – the latter declining by -8% in nominal terms as of December 2019. There is little hope for a near-term rebound given the certain hit to global growth and export demand from virus-stricken China. What the BoJ should be more focused on: Given that Japan is still an economy with a large manufacturing sector that is levered to global growth, the BoJ should remain focused on the path for Japanese exports. A bigger risk, however, comes from the Japanese yen, which has remained very stable over the past year. It has proven very difficult to generate any rise in Japanese inflation without some yen weakness, and with headline CPI inflation now only at +0.2%, a burst of yen strength would likely tip Japan back into outright deflation. Bottom Line: The BoJ is now stuck in a very bad spot, with no real ability to provide a major monetary policy stimulus for the stagnant Japanese economy. At best, all the central bank could do is deliver a small interest rate cut and hope for a quick rebound in global manufacturing activity and/or some yen weakness to boost flagging inflation. Bank Of Canada Chart 7Bank of Canada: Focus On Housing & Capital Spending The Bank of Canada (BoC) surprised many observers by keeping policy on hold last year, even as central banks worldwide engaged in various forms of monetary easing to offset the effects of the global manufacturing downturn. The BoC’s recent messaging has been relatively neutral, in our view, although Governor Stephen Poloz has not completely dismissed the possibility of rate cuts in his speeches. The markets are strongly convinced that the BoC will need to belatedly join the global easing party, with -32bps of rate cuts now priced into the CAD OIS curve according to our BoC Discounter (Chart 7) What the BoC seems most focused on: The BoC remains highly concerned over the high level of Canadian household debt, especially given how Canadian consumer spending has been highly geared towards trends in house price inflation over the past few years. This is likely why the BoC has been reluctant to cut policy rates as “insurance” against the effects of a prolonged global growth slump, to avoid stoking a new Canadian housing bubble. Interestingly, the commentary from BoC officials has taken on a bit more dovish tone whenever USD/CAD has threatened to break down below 1.30, suggesting some fears of unwanted currency appreciation. What the BoC should be more focused: The BoC should continue to monitor developments in the Canadian housing market, given the implications for consumer spending and, potentially, financial stability if there is another boom in house prices. The central bank should also pay even greater attention than usual to the subdued level of oil prices, which has triggered a deep slump in the oil-rich Alberta province that has weighed on the overall level of Canadian business investment spending. Persistently soft oil prices would also force the BoC to continue resisting strength in the Canadian dollar. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Bottom Line: The BoC appears under no pressure to make any near-term interest rate adjustments, especially with realized inflation now sitting at the midpoint of the BoC’s 1-3% target band. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Reserve Bank Of Australia Chart 8Reserve Bank Of Australia: Focus On Underemployment & Housing The Reserve Bank of Australia (RBA) has been very transparent over the past year, loudly signaling a dovish bias and following through with 75bps of rate cuts that took the Cash Rate to a record low of 0.75%. The latest messaging has been a bit more balanced, while still leaving the door to additional rate cuts if the economy worsens. Markets are expecting at least one more easing, with -24bps of rate cuts over the next twelve months priced into the AUD OIS curve, according to our RBA Discounter (Chart 8). What the RBA seems most focused on: The RBA’s main concerns have centered around the persistent undershoot of Australian inflation, with core inflation remaining below the central bank’s 2-3% target band since the beginning of 2016. The central bank has attributed this to persistent excess capacity in the Australian labor market, as evidenced by the elevated underemployment rate. The RBA is also paying close attention to the Australian housing market and its links to consumer spending, with house prices already responding positively to last year’s RBA rate cuts. The outlook for exports is also on the RBA radar, particularly after the recent surge that lifted the Australia trade balance into surplus but is now at risk from a plunge in Chinese demand. What the RBA should be more focused on: We agree that the labor market should be the main focus for the RBA, particularly the underemployment rate which is still high at 8.3%, signaling that core CPI inflation should remain subdued (bottom panel). We also see the RBA as potentially being more sanguine about the risks of a renewed upturn in the housing market than many observers expect, since that would provide a potential offset to a likely pullback in exports which are now a record 25% of GDP (middle panel). Bottom Line: The RBA still has a clear dovish bias, even though they are currently on hold to assess the impact of last year’s easing. RBA Governor Philip Lowe noted in a recent speech that more cuts may be necessary “if the unemployment rate deteriorates”, suggesting that the labor market is the main area of focus for the central bank. Reserve Bank Of New Zealand Chart 9Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation The Reserve Bank of New Zealand (RBNZ) was one of the more dovish central banks in 2019, cutting the Cash Rate by 75bps to a record low of 1%. The overall tone of the central bank’s recent commentary remains cautious, but has taken on a more balanced tone. Markets are priced appropriately, with only -13bps of rate cuts over the next twelve months discounted in the NZD OIS curve according to our RBNZ Discounter (Chart 9). What the RBNZ seems most focused on: The latest messaging from the RBNZ has highlighted the downside risks to New Zealand from weak global growth, but those are now more manageable since the central bank estimates the economy is operating at full employment. In its latest Monetary Policy Statement (MPS), the RBNZ noted that the economy has been able to weather the weakness in global growth thanks to the positive terms of trade effect from elevated New Zealand export prices – a trend that the central bank expects will persist in 2020 even if external demand remains sluggish (middle panel). The central bank has also expressed some concern over the recent pickup in domestically-driven inflation measures, with core CPI inflation back above 2% (bottom panel). What the RBNZ should be more focused on: The RBNZ is right to focus on global growth, particularly given the coming demand shock from virus-stricken China. While the New Zealand dollar has always been a critical variable for the RBNZ in its policy decisions, the currency now takes on added importance given the central bank’s expectation that export prices and the terms of trade will remain elevated. If the latter turns out to be wrong, the RBNZ will be far more likely to take actions to ensure that the Kiwi dollar stays undervalued. Bottom Line: The RBNZ still has a dovish policy bias, but the hurdle to deliver additional rate cuts after last year’s easing seems a bit higher now. It would likely take a major downturn in global growth, combined with a decline in New Zealand export prices and some cooling of domestic inflation, to get the RBNZ to cut again in 2020. Investment Conclusions Based on our “whirlwind tour” of the major developed market central banks in this report, we can make the following conclusions regarding the expected path of interest rates, and bond yields, in these countries: There are no central banks with anything resembling a hawkish bias – not surprising in the current slow global growth environment with heightened uncertainty. The least dovish central banks are the BoC and the RBNZ, which are not signaling any urgency to cut rates. The most dovish central bank is the RBA, which is indicating a clear willingness to cut again if domestic growth deteriorates. The Fed and the BoE are somewhere in the middle of the “dovishness” spectrum, with both likely willing to ease policy but only under a specific set of circumstances. The ECB and BoJ are clearly boxed in having policy rates already below the zero bound, limiting their ability to ease further if needed. In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months.  Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-42bps), Canada (-32bps), Australia (-24bps) and the UK (-19bps). At the same time, the fewest cuts are priced in Japan (-6bps), the euro area (-7bps) and New Zealand (-13bps). In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months. The odds seem more “fair” in the other countries, in terms of the size of rate cut expectations versus the probability of those cuts actually being delivered because of domestic economic considerations. What does this all mean for global bond investing this year? For that we can turn to our Global Golden Rule framework, which links expected returns of government bonds versus cash to the difference between actual and expected rate cuts.1 US Treasuries and Canadian government bond yields are most at risk of underperforming their global peers in 2020 as the Fed and BoC disappoint the current dovish rate cut expectations discounted in interest rate markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

A dangerous break up in historical correlations marked this year’s trading, as both the VIX and the SPX became positively correlated. Worrisomely, since 2018 every time such a breakdown occurred, the broad market subsequently suffered a setback (see chart). Importantly, while the SPX vaulted to all-time highs, the VIX neither collapsed to all-time lows nor cyclical lows. Equity market volatility also stays stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1  Bottom Line: VIX resilience highlights that there is more stress beneath the equity market’s surface than first meets the eye. Please refer to this Monday’s Weekly Report for more details.   1    https://us.spindices.com/vix-intro/