Developed Countries

Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle Chart 4Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… Chart 6…Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

The GAA DM Equity Country Allocation model is updated as of August 31, 2019.   Currently, the model still favors Spain, Italy, Germany, the Netherlands, Switzerland, and Australia at the expense of the U.S., Japan, the U.K., France and Canada, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) As shown in Table 2 and Chart 1,  Chart 2 and  Chart 3, the overall model underperformed the MSCI World benchmark by 6 bps in August, driven by 1 bp of outperformance from Level 2 model, and 6 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 82 bps, with 290 bps of outperformance by Level 2 model, offset by 51 bps of underperformance from Level 1. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of August 31, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model continues to favor a mixed bag of sectors, given the current increased level of uncertainty, and continued lack of evidence that global growth is bottoming. Despite the current liquidity phase tilting the model to favor high-beta sectors, weak growth and momentum inputs offset that. The valuation component continues to remain muted across all sectors. The model is now overweight five sectors in total, two cyclical versus three defensive sectors. The overweight sectors are Consumer Discretionary, Information Technology, Consumer Staples, Healthcare and Utilities. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com              

Highlights Our cyclical view is unchanged, … : Despite the evident risks from escalating trade tensions, soft global economic data, and widespread recession concerns, we expect the expansion and the bull markets in spread product and equities will remain intact. … as fiscal largesse has provided the U.S. economy with ample cushion: Per the IMF’s estimates, the fiscal stimulus package centered on the Tax Cuts and Jobs Act of 2017 amounted to about 70 basis points (“bps”) of fiscal thrust in 2018 and another 40 bps in 2019. But how is Congress’ unprecedented experiment shaping up beyond 2019?: The first-order impact of the tax cuts on government revenues is straightforward. The ultimate net effect turns on how lower taxes alter the course of corporate investment and work force participation. The CBO’s latest projections have the federal deficit widening by an additional $1 trillion over the next decade: Supply-side benefits from the 2017 Act have underwhelmed so far, and the fate of the federal budget depends on lawmakers’ restraint. We are long-run bearish on Treasuries and the dollar. Feature The fundamental backdrop remains mixed in the United States and the rest of the world. Global trade has slowed, and the world is experiencing a sharp manufacturing slowdown. The consensus of BCA researchers expects that manufacturing will soon find a footing, and the global economy will revive, helped along by easier monetary policy. A fiscal pick-me-up is long overdue, and would be especially welcome, but we are not holding our breath, especially when Japan finally seems prepared to impose its repeatedly-postponed VAT increase. Opinion within BCA is notably split, and the glass-half-full and glass-half-empty camps remain far apart. The mixed tone of the macro data offers something for bulls and bears, and contributed to the sharp single-day moves that characterized August’s equity action. Although the S&P 500 moved at least 1% in half of its sessions, however, it was down less than 2% for the month through Thursday. After slipping from its 3,000 perch amidst a 5% decline across August’s first three sessions on renewed trade hostilities, it traded in a narrow range between 2,825 and 2,945 the rest of the way (Chart 1). Chart 1Big Daily Swings, But A Tight Monthly Range The Fed is caught in a loop of responding to inorganic shocks. It tightened policy in 2018 while nervously looking over its shoulder at a sizable injection of procyclical fiscal stimulus that wound up exerting less overheating pressure than it had feared. Now it finds itself uncomfortably drawn into the vortex of the trade war, cutting rates to keep the expansion from being snuffed out prematurely by self-inflicted wounds. Various Fed officials seem to be chafing under the burden of serving as a bulwark against the drag from the tariff fights. As Chair Powell admonished in his Jackson Hole address, “[M]onetary policy … cannot provide a settled rulebook for international trade.” Like it or not, the Fed is stuck cleaning up other policymakers’ messes. Jackson Hole would normally have brought down the curtain on any meaningful market news until after Labor Day. But Bill Dudley, the head of the New York Fed from 2009 to 2018, had other ideas. He argued in a Bloomberg opinion column that the Fed should refuse to abet foolhardy trade policy with rate cuts that offset its ill effects. He went on to posit that it is within the Fed’s remit to set policy with an eye toward influencing the outcome of the 2020 presidential election. Dudley’s grenade enlivened a slow news day and had the effect of unifying the economics community in condemnation of his polemic. The Fed swiftly distanced itself from the comments, reiterating that its “decisions are guided solely by its congressional mandate,” and that “political considerations play absolutely no role.” It is hard to know what Dr. Dudley intended to accomplish, but he ensured that we will be at BCA’s 40th Annual Investment Conference bright and early on Friday, September 27th when he kicks off its second day. Initial Estimates Soon after the 2017 Tax Cuts and Jobs Act was passed, the Congressional Budget Office (“CBO”) assessed how its provisions would affect the U.S. economy. Although calculating the components involves myriad complex estimates, the budget equation is quite simple: Budget Surplus/(Deficit) = Revenues – Outlays. Cutting taxes clearly reduces revenues, and the reductions in individual tax rates, partially offset by limits on deductions, were estimated to cost the federal government roughly $300 billion over the next decade. The 10-year tab for lower corporate rates, and immediate expensing of business investments through 2022, was estimated to run about $1 trillion. Relief from some spending constraints brought the total estimated cost to $1.7 trillion. A trillion here, and a trillion there, and pretty soon you’re talking real money. Though the Act was sure to worsen the deficit, it contained provisions meant to encourage investment and labor supply. Corporate tax cuts and the full immediate expensing of investments in software and eligible equipment were expected to permanently increase the nation’s capital stock, thereby boosting the trend pace of productivity growth. A reduced individual income tax burden was expected to encourage more people to enter the workforce and incumbents to work longer hours. Ultimately, the CBO projected that the Act would boost the level of real potential GDP by 0.7%, on average, through 2029.  Six Quarters On It follows that people might work more if they are able to keep more of what they earn, but the data since individual income tax rates were reduced at the beginning of 2018 are inconclusive. The labor force participation rate has been treading water for several years (Chart 2, solid line), as it battles against the drag from baby boomer aging (Chart 2, dashed line). Prime-age labor force participation has risen very slowly off of its 2015 bottom, and has spent 2019 unwinding its gains from late last year (Chart 3). Average weekly hours worked remain locked in the narrow range that has prevailed since 2012 (Chart 4). Though it is difficult to isolate the drivers of participation gains, the part rate’s erratic 2018-9 course suggests that the Act has not yet had a discernible work force impact. Chart 2The Baby Boomers Have Become A Demographic Headwind Chart 3Labor Supply ##br##Gains ... Chart 4... Have Yet To Materialize Residential investment, which lost some tax subsidies via the Act’s limits on mortgage interest and state and local tax deductions, has declined in every quarter since it was passed, and we back it out of fixed investment to assess the Act’s impact on corporate investment. As with labor supply, the record so far is mixed. Fixed investment (ex-residential investment) built on its 4Q17 acceleration over the first three quarters of 2018 only to slide in the three subsequent quarters (Chart 5). Publicly traded corporations have proven more eager to share their cash windfall with shareholders than they have been to invest it. Chart 5Investment Stimulus? What Investment Stimulus? Looking Ahead – Activity Effects We accept that lower individual income tax rates make work more attractive. People respond to incentives, and more after-tax pay, all else equal, should encourage some discouraged workers to rejoin the labor market and push some of the currently employed to want to work more. The changes are modest, though, with take-home pay increasing $324, or 2%, for someone earning $20,000, and $1,299, or 3%, for someone earning $50,000 (Table 1). We see the Act as having no more than a modest marginal effect on labor supply, though it should help boost consumption until households begin to factor in seemingly inevitable future tax hikes. Table 1Take-Home Pay Is Up, But Not By Much If the 2017 Act really is going to boost the potential trend rate of growth, it will have to do so by pushing the rate of productivity growth higher.1 Workers are able to produce more in a given block of time when they’re endowed with more and better tools, and new tools require investment. If fixed investment doesn’t accelerate, there’s no reason to expect that productivity will (Chart 6). The capex outlook from the NFIB survey and the various Fed regional manufacturing surveys is iffy, and BCA has previously noted how an aging population and a shift to more capital-light businesses may restrain investment. Chart 6Investment Drives Productivity It will not be an easy matter to boost productivity by boosting capex, though some of businesses’ after-tax cash will likely find its way to investment. To help the process along, Congress incorporated a familiar provision: accelerated depreciation. Accelerated depreciation’s empirical record as an investment catalyst is hardly clear (Box), and we don’t find its theoretical basis terribly compelling. We think the Act’s trend growth impacts are more likely to disappoint the CBO’s expectations than exceed them. Investment confronts demographic headwinds, too. Pushing trend growth higher will not be easy. Box - An Anodyne Prescription A celebrated provision of the Act allows for the immediate expensing of qualified investments until 2022. Accelerated depreciation programs, which allow for more rapid expensing of investments in property, equipment and other depreciable assets in an attempt to stimulate investment, are a stock measure in lawmakers’ stimulus toolkit, but their effectiveness is hardly assured. For one thing, they’re not new, and businesses may have built up an immunity to them, as they have been a continuous feature of the tax code since 1981. The immediate expensing allowed under the 2017 Act is a form of bonus depreciation, which was initially introduced in the wake of the September 11th attacks. It has remained in place for all but one subsequent year, and though investment peaked during the other stretch that provided for immediate write-offs (September 2010 - December 2011), we are skeptical that it will materially increase the size of the capital stock going forward. Accelerated depreciation schemes encourage investment via the time value of money. They do not increase the depreciation benefit provided by a particular investment, they simply speed up its recognition. Savvy businesses may adjust the timing of their investments to take advantage of temporary bonus periods, but they will not necessarily invest more.2 With rock-bottom interest rates squeezing the time value of money, it’s possible that bonus depreciation’s impact may be especially muted this time. Looking Ahead – The Budget Deficit The CBO’s updated projections through 2029, released two weeks ago, call for the budget shortfall to widen by $800 billion more than previously estimated in January. Despite a downward revision of over $1 trillion in projected interest expense, additional spending has weakened the deficit outlook. It appears that elected officials simply can’t help themselves. In a climate in which neither Congress nor voters evince any desire to rein in the deficit, it seems foolishly naïve to assume that future sessions of Congress will abide by built-in expenditure limits like sunset provisions and spending caps. Although the CBO projects that federal revenues will rise across its 10-year forecasting horizon, they will not do so fast enough to keep up with outlays swollen by interest payments on the growing pile of Treasuries (Chart 7). The CBO sees debt as a share of GDP rising to 95% by 2029, within reach of the all-time high recorded after World War II (Chart 8). Financial markets don’t care now, and we don’t think they will any time in the near future, but the CBO’s baseline projections, which assume future Congresses abide by their stated commitments, probably represent an optimistic scenario. We are more inclined to expect the alternative scenarios, in which sunset provisions are ignored, and pre-set spending caps are set aside, to come to pass. Chart 7A Widening Budget Gap ... Chart 8... Leads To An Increased Debt Burden Investment Implications Chart 9The Dollar's Long-Run Direction Is Down Treasury yields are currently within sight of their July 2016 Brexit-inspired lows, and may well revisit them. Negative yields are a common feature well out the maturity curve in core Europe and Japan. A sustained move higher is not in the cards in the near term, and though we do expect yields to rise as the global economy gains some traction later this year, we do not foresee a disruptive move higher even over the next couple of years. The very long-term outlook for Treasuries is lousy, however, and the dollar also faces secular pressures (Chart 9). The U.S. is not likely to turn into Japan, but the next decade’s returns will likely pale beside those earned since 1982. We are congenitally optimistic about humanity, and Americans seem to have a particular knack for pulling rabbits out of hats. We do not see the U.S. turning into Argentina, Greece or even Japan. The debt burden will weigh on potential growth down the road, however, as debt service will limit Congress’ ability to deploy countercyclical adjustments and longer-term investments, and debt issuance will eventually crimp private entities’ access to capital. All of these factors will limit potential economic growth and contribute to softening returns on equity and credit. We continue to foresee tepid returns over the next ten years relative to the returns investors have grown accustomed to over the last four decades, and we would much rather borrow at current rates for the next 20 or 30 years than lend at them.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Economic growth is the sum of growth in productivity and growth in the size of the labor force. Since the Act does not bear on immigration or birthrates, productivity represents its best shot at moving the growth needle. 2 Congressional Research Service Report RL31852, The Section 179 and Section 168(k) Expensing Allowances: Current Law and Economic Effects, by Gary Guenther, May 1, 2018.  

Global equities peaked in late-January 2018 when the U.S. fiscal easing-related euphoria “positively infected” global investor sentiment. Since then, the SPX has moved laterally, closing higher by 0.52% (as of August 28, 2019 close). But, looking underneath the hood is revealing. The top panel of the chart shows the unweighted returns of the S&P 500 GICS1 sectors since January 2018. The bottom panel shows the weighted returns. Clearly the tech sector is the only pillar keeping equities afloat given the higher than 20% SPX weight they command. Within tech, software stocks have the largest weight and that juggernaut explains most of the tech sector’s returns since January 2018. One key reason why these secular growth stocks are near all-time highs (along with utilities and real estate outperformance) is the drubbing in U.S. Treasury yields, especially since the November 2018 peak. Nevertheless, there is a big risk looming: the trade war infiltrating tech stocks similar to the rest of their cyclical brethren. Already, two tech stocks (bellwether CSCO and ADSK) blamed the trade war for their soft guidance, and the longer the war lasts, the larger the list of profit warnings will get. Tack on the rising U.S. dollar, and profit expectations are at risk of disappointment, as the tech sector’s international sales exposure stands near 60%. As a reminder, we remain overweight the S&P software index, but we have increased our trailing stops in order to protect gains. Such a downgrade to neutral will also trigger the downgrade alert on the S&P tech sector and push this index to underweight from currently neutral. Bottom Line: The broad market is skating on thin ice and if the tech sector breaks down, so will the SPX. We reiterate our cautious overall equity market stance on a cyclical 3-12 month time horizon. ​​​​​​​​​​​​​​

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 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