Developed Countries

There will be no U.S. Bond Strategy report next week. Our regular publication schedule will resume on September 10th, with our Portfolio Allocation Summary for September. Highlights Fed: Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it. Expect another 25 basis point rate cut in September. Duration: Stronger economic data will eventually lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. Yield Curve & Recessions: An inverted yield curve signals that the market views monetary policy as restrictive. Restrictive policy should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. Feature Chart 1Markets Want More Easing And The Fed Should Accommodate Bond investors had their hands full last week, as comments from Fed officials produced an unusually wide range of views. The hawks were most vocal early in the week as Boston Fed President Eric Rosengren, Kansas City Fed President Esther George and Philadelphia Fed President Patrick Harker all made the case for leaving rates at current levels, even as the market continues to price-in another 25 basis point rate cut in September, followed by an additional 50 basis points of cuts between October and February (Chart 1). Fed Chairman Jerome Powell, however, did not try to shift market expectations one way or the other during his Jackson Hole speech on Friday. This suggests that he is probably comfortable with current bond market pricing. In our opinion, we will see another 25 basis point rate cut in September and the Fed is justified in doing so. The Fed Can’t Fight The Markets, And It Shouldn’t Chart 2Keep Financial Conditions Supportive In the current environment, monetary policy exerts its greatest influence on the economy via its impact on broad financial conditions. Easier financial conditions lead to stronger growth and higher inflation in the future (Chart 2), and the Fed must ensure that financial conditions remain accommodative during the current global slowdown. This means that the Fed’s most important job is to ensure that investors perceive Fed policy as supportive for equities and corporate credit. In other words, unless Chairman Powell wants to slow the economy, he must bow down to the markets and deliver enough monetary easing to keep broad financial conditions accommodative. The minutes from the July FOMC meeting, released last week, suggest that the Fed understands this dynamic and will act as appropriate. In their discussion of financial market developments, participants observed that financial conditions remained supportive of economic growth, with borrowing rates low and stock prices near all-time highs. Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks. Chart 3No Sign Of Rising Inflation Expectations... Simply, if the market expects another rate cut in September, the Fed would be wise to deliver. Otherwise, broad financial conditions could tighten sharply, making it more difficult for economic growth to recover. It is not always the case that the Fed should act to ensure that financial conditions remain accommodative. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations.1 However, neither of those conditions are in place today. The cost of inflation compensation priced into long-maturity TIPS has collapsed, and it is well below the 2.3% - 2.5% range that would be consistent with well-anchored inflation expectations near the Fed’s target (Chart 3). Survey measures of long-dated inflation expectations have been more stable, but are not threatening to move significantly higher (Chart 3, bottom panel). Equally, financial asset valuations are nowhere near “bubbly” (Chart 4). The risk premium priced into corporate bonds after accounting for expected default losses is above levels seen early last year, while the S&P 500’s 12-month forward Price/Earnings ratio is below its early-2018 peak. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations. Further, the 2-year/10-year Treasury slope recently inverted and the broad trade-weighted dollar continues to appreciate (Chart 5). Both of these factors suggest that the market views Fed policy as insufficiently accommodative. St. Louis Fed President James Bullard bluntly summed up the situation in an interview last week, saying that it is “our job to get the yield curve to be un-inverted”. Chart 4...Or Excessive Financial ##br##Asset Valuation Chart 5The Case For More Accommodative Monetary Policy We agree with this sentiment. Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it, in an effort to un-invert the yield curve. The Economy Must Lead Chart 6Still Waiting For A Rebound In Global Growth But the Fed can’t un-invert the yield curve all on its own. The Fed can pull down the short-end of the curve, but it needs to economy to cooperate if it wants to boost long-end yields. In fact, if the global economic data improve, then the market will no longer require Fed rate cuts to keep financial conditions accommodative. If the economic data improve a lot, then the market might even be able to live with rate hikes and still maintain supportive broad financial conditions. We haven’t yet seen much evidence of improvement in the global economic data, but we remain confident that a rebound will take hold before the end of the year.2 Flash PMI data for August were released last week and showed a drop in the U.S. figure to below the 50 boom/bust line (Chart 6). The Flash data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. In contrast with the weaker PMI data, Leading Economic Indicators (LEI) are showing some signs of strength. Although both the U.S. and Global (excluding U.S.) LEIs remain at below-average levels relative to their trailing 12-month trends (Chart 7), the Global (ex. U.S.) index bottomed several months ago and the U.S. index ticked higher last month. Troughs in the LEIs tend to precede troughs in both the Global PMIs and bond yields.  Chart 7Leading Economic Indicators Suggest The Rebound Might Be Soon Bottom Line: The Fed must keep financial conditions accommodative, and this means satisfying the bond market’s expectations for further rate cuts. Eventually, stronger economic data will lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. The Inverted Yield Curve And Recession Risk We have received a lot of client questions on the topic of using the yield curve to forecast recessions. In this week’s report we explain our views about how the inverted yield curve should be interpreted. In short, we think an inverted yield curve should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. The Flash PMI data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. We start by recognizing that many variables have strong track records at forecasting recession, and those variables can be grouped into two broad categories: Financial market indicators (including the yield curve, stock market, oil price, etc…) Economic indicators (including initial jobless claims, unemployment rate, housing starts, etc…) In general, financial market indicators give more advance warning of recession but they are also prone to sending false signals. Economic indicators, on the other hand, are less prone to false signals, but often provide little (if any) advance notice. With this in mind, we turn to Chart 8. The top panel of which shows the New York Fed’s popular Recession Probability Indicator, an indicator derived purely from the 3-month/10-year Treasury slope. We also calculate the same model using the 2-year/10-year slope, but the results are not materially different. Chart 8Recession Probability Indicators The top panel of Chart 8 shows the strengths and weaknesses of using financial market data to forecast a recession. The New York Fed’s model started to rise about 3 years prior to the last recession and 5 years prior to the 2001 recession. The model also fluctuated up and down several times in the late 1990s, suggesting that recession risk was lower in 1998 than in 1996 even though the recession was actually 2 years closer. In general, the model clearly illustrates that the yield curve flattens as the economic recovery ages, but also that the yield curve can provide a recession signal far in advance of the actual recession. The model’s signal can also reverse if the yield curve re-steepens. The bottom panel of Chart 8 shows the New York Fed’s yield curve-based Recession Probability Indicator alongside our own recession indicator, one that is based on several different variables (including the yield curve). Our model is designed to give less lead time than a pure yield curve model, but also fewer false signals. Once again, the late-1990s are instructive. The yield curve-only model was sending a recession signal of varying magnitudes for 5 years before our multi-factor model shot higher in 2001. What can we conclude from looking at these different recession models? Essentially, we should view an inverted yield curve as a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. Policy could remain restrictive for several years before the recession takes hold, or policy could move from restrictive to accommodative and the yield curve’s recession signal could vanish. Incorporating The Term Premium, Is This Time Different? Some publications at BCA have made the case that the yield curve’s recession signal is distorted in this cycle because of the deeply negative term premium. While this could be true in theory, in practice, we think it would be unwise to dismiss what the yield curve is telling us about the current stance of monetary policy. Chart 9Uncertainty Around The Term Premium Bond yields consist of two components, short rate expectations and a term premium. The yield curve’s power as a recession indicator comes from the rate expectations component. Assuming a constant term premium, an inverted yield curve means that the bond market expects the overnight rate to fall in the future. This is more likely to happen in a recession. However, if the term premium were deeply negative at the long-end of the yield curve, then an inverted yield curve might simply reflect the negative term premium and not an expectation that the fed funds rate will decline. In theory, this could be the case if, for example, the equity hedging value of Treasury bonds is perceived to be much higher now than in the past. In that case, investors might be willing to pay to take duration risk in order to gain the perceived diversification benefits. That is a plausible story. The problem is that we cannot verify it in the data because bond term premia cannot be accurately estimated. For example, one popular term premium estimate, the New York Fed’s Adrian, Crump and Moench (ACM) estimate, placed the 10-year zero coupon term premium at -84 bps on July 22. On that same date, the spot 10-year Treasury yield was 2.06%. This implies that the market’s 10-year average fed funds rate expectation was (206 bps – (-84 bps)) = 2.9%. In other words, the ACM estimate tells us that on July 22 the market expected the fed funds rate to average 2.9% over the next 10 years. This seems highly implausible, given that the New York Fed’s Survey of Market Participants, taken that same day, shows that the median market participant expected the fed funds rate to average 2% over the next 10 years (Chart 9). According to that median survey response, the 10-year term premium was +6 bps on July 22, not -84 bps! The point is not that survey measures of term premia are preferable to more sophisticated models of the ACM variety. We simply wish to point out that term premia estimates are highly uncertain, and the actual term premium on any given day is impossible to pin down. Once we recognize this fact, then we should at least be skeptical of claims that a negative term premium is distorting the recession signal from the yield curve. Given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value. Bottom Line: The proper interpretation of an inverted yield curve is that it is a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. It is conceivable that a deeply negative term premium is currently distorting the yield curve’s signal about the stance of monetary policy. But given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 We have made the case that inflation expectations and financial conditions are the two most important factors to monitor when tracking Fed policy. For further details please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 2  We elaborated on the reasons to expect a rebound in global growth in the U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?” dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. Weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index, all signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index.   Waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P electrical components & equipment (EC&E) index.  Recent Changes There are no changes to the portfolio this week. Table 1 Feature The S&P 500 traded in an uncharacteristically tight range last week before falling apart on Friday on the back of a re-escalation in the U.S./China trade war. Worries of recession also resurfaced. Not only did the MARKIT flash manufacturing PMI break below the 50 expansion/contraction line, but it also pulled down the MARKIT flash services PMI survey that barely held above the boom/bust line. Adding insult to injury, the 10/2 yield curve slope inverted anew last week further fanning these recession fears. Worrisomely, consumer sentiment took a hit recently according to the University of Michigan survey (top panel, Chart 1). Importantly, what caught our attention was the following commentary: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession.” While the consumer is the last and most significant pillar standing for the U.S. economy, reflexivity may spoil the party and a recession may become a self-fulfilling prophecy. This is the message the bond market is sending and it is warning that the path of least resistance is a lot lower for stocks (bottom panel, Chart 1). Chart 1“The First Cut Is The Deepest” Economists are also downgrading their U.S. real GDP growth estimates and that forecast now stands at 2.3% for the current year according to Bloomberg. While the recession alarm bells are not sounding off, these downward revisions bode ill for stocks (Chart 2)  Chart 2Watch Out Down Below Moving to another part of the fixed income market, stress is slowly building in the high yield market especially given the recent tick up in bankruptcies and the blind sides that cove-lite loans now pose to bond investors. As a reminder, the U.S. high yield option adjusted spread (OAS) troughed last September and continues to emit a distress signal for the broad equity market (junk OAS shown inverted, top panel, Chart 3). Chart 3Mind The Gaps With regard to global growth, it is still missing in action, and given that Dr. Copper is on the verge of a breakdown, a global growth recovery is a Q1/2020 story at the earliest. This week we update a consumer discretion­ary subindex and also highlight an industrials sector subgroup. Chart 4SPX: The Next Shoe To Drop? Chart 5Risk To View Other financial market variables concur that global growth is elusive. J.P. Morgan’s EM FX index has broken down and EM equities are also hanging from a thread. The EM high yield OAS has broken out signaling that the risk off phase has yet to fully run its course (EM junk OAS shown inverted, bottom panel, Chart 4). Finally, there is a short-term risk to our cautious equity market view. Indiscriminate buying in U.S. Treasurys has now pushed the 10-year yield down almost 180bps from last November’s peak deeply in overvalued territory. While such a move is not unprecedented, buying may be exhausted and in need of at least a short-term breather (Chart 5).     Netting it all out, the sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. This week we update a consumer discretionary subindex and also highlight an industrials sector subgroup. Empty Spaces When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (Chart 6). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. Chart 6Stay Checked Out Of Hotels   Already discretionary retail sales have taken the back seat and non-discretionary retail sales are in the driver’s seat. In fact, the top panel of Chart 7 shows that the relative retail sales backdrop has plunged to levels last seen during the GFC, warning that relative share prices have ample room to fall. Drilling deeper in the consumption data is instructive. Lodging outlays are decelerating and are also trailing overall PCE. The implication is that relative profits will likely underwhelm sustaining the 18-month long de-rating phase (middle & bottom panels, Chart 7). On the operating front the news is equally dour. While selling prices are expanding, the relentless construction binge will lead to a mean reversion sooner rather than later (bottom panel, Chart 8).   Chart 7De-rating Phase To Gain Steam Chart 8Margin Squeeze Looming   Tack on the ongoing assault from the new sharing economy unicorns like Airbnb, and industry pricing power will remain in check in coming quarters. Similarly, the ISM non-manufacturing price subcomponent is warning that a deflation scare is looming in the lodging industry (second panel, Chart 8). Not only are selling prices under attack, but also labor-related input costs are on fire. The sector’s wage inflation is climbing at a 3.9%/annum pace or roughly 120bps higher that the overall employment cost index (third panel, Chart 8). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel, Chart 8). Importantly, the overall ISM services survey best encapsulates the bearish backdrop of the S&P hotels, resorts & cruise lines index. Historically, relative share prices have been moving in tandem with the ISM non-manufacturing survey and the current message is that selling pressures on relative share prices will persist in the coming months (Chart 9). Chart 9Heed The Message From The ISM Services Survey In sum, weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index. Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH. Short Circuited The S&P EC&E index broke down recently (top panel, Chart 10) and we reiterate our underweight recommendation in this industrials sector subgroup. While it is tempting to bottom fish here especially given oversold technical and bombed out valuations (bottom panel, Chart 11), a number of the indicators we track suggest that more losses are around the corner. Chart 10Sell The Weakness Chart 11Good Reasons For Valuation Discount   First the trade-weighted dollar has broken out to fresh cyclical highs despite the collapse in the 10-year yield. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, middle panel, Chart 10). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, bottom panel, Chart 10). Second, while industry new orders have been resilient, the massive inventory buildup dwarfs new order growth and warns that a deflationary liquidation phase is looming (middle panel, Chart 11). In fact, the recent drubbing in the ISM manufacturing prices paid subcomponent portends a deflationary industry phase (third panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Other operating metrics are also warning that EC&E profits will underwhelm. Industry weekly hours worked have plunged and sell-side analysts have been aggressively cutting EPS estimates (bottom panel, Chart 13). On the productivity front, executives have not adjusted labor cost structures to lower running rates yet (second panel, Chart 13) and, thus, our EC&E productivity gauge (industrials production versus employment) is contracting which bodes ill for industry earnings (third panel, Chart 13). Chart 12Weak Profit Backdrop Chart 13Deteriorating Operating Metrics   Finally, our S&P EC&E EPS growth model does an excellent job in encapsulating all these moving parts and is signaling that the path of least resistance is lower for EPS growth in the coming months (bottom panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Bottom Line: Stay underweight the S&P EC&E index. BLBG: S5ELCO – AME, EMR, ETN, ROK.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Sovereign bond yields have cratered over the last few months, … : Over the last three months, 10-year yields in the U.S., France, Germany, Switzerland and Australia have fallen by 71, 64, 53, 54, and 67 basis points, respectively. … and the Treasury curve has experienced a significant bull flattening, … : Month-to-date total returns for the Barclays Bloomberg Long, Intermediate and 1-3-Year Treasury Indexes are 9.2%, 1.6% and 1.1%, respectively. … indicating that the bond market thinks more rate cuts are in store: The textbook interpretation of an inverted curve is that monetary policy is too tight and needs to be loosened, but technical factors have amplified the flattening pressure. Is the bond market reacting to weakening growth prospects, or uber-dovish central banks?: The answer has implications well beyond the fixed-income universe. It could mean the difference between an economic slowdown and a market melt-up. Feature BCA researchers convened last week for our monthly View Meeting, much of which was given over to the global decline in sovereign bond yields. Does their plunge owe more to weakening growth prospects or central banks’ synchronized dovish pivot? There have surely been elements of both; after all, central banks wouldn’t be so dovish if they weren’t concerned about the growth outlook. It is clear to our fixed-income strategists that the yield move has overshot the data, however, and they mainly attribute the overshoot to monetary policy. No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.1 The pell-mell rush to cut rates is emblematic of a global scramble for competitiveness. No central bank wants its economy to be caught without a buffer while other economies are busily reinforcing theirs. The Message From The Bond Market Trade tensions are a legitimate threat to global economic growth already challenged by a downswing in the global manufacturing cycle. A recession is a possibility, but it is hardly a foregone conclusion. We agree with our fixed-income colleagues that the yield selloff has overrun the economic fundamentals. Last week’s preliminary European manufacturing PMIs suggested that manufacturing may finally be stabilizing, and there is still no evidence that the manufacturing downturn has infected the services sector (Chart 1). A recession is hardly a foregone conclusion. 10-year Treasury yields have been falling sharply since their 3.25% peak in early November, and the current leg down is the third in a series of sharp declines (Chart 2, top panel). Global sovereign yields have followed the same pattern (Chart 2, bottom panel), but the latest plunge is as much a reflection of ubiquitous easing biases as it is of new concerns about economic weakness. That may sound like a minor point, of interest only to macro specialists, but it has import for all investors. If the yield decline isn’t signaling new softness, then easier financial conditions will be free to act as a tailwind for risk assets. Chart 1Services Are Holding Up ... Chart 2A Brief Inversion ... But Yields Are Freefalling Neither investment-grade (Chart 3, top panel) nor high-yield corporate bond spreads evince any particular concern about the economy (Chart 3, bottom panel). Although they’ve ticked up, they remain near the bottom of their post-crisis range, and are nowhere near the levels they reached in 2011-12, during the federal budget showdown/U.S. downgrade and the flare-up of the Eurozone crisis, or in 2015-16, during the last manufacturing recession. With banks still easing lending standards for corporate and industrial borrowers (Chart 4), spreads won’t undergo a systematic widening. Borrowers do not default as long as there is a lender willing to roll over their maturing obligations, so tighter credit standards are a precondition for spread-widening cycles. Chart 3No Sign Of Stress Among Corporate Borrowers ... Chart 4... And Banks Aren't Applying Any Pressure The Message From The Housing Market Chart 5Lower Rates Have Yet To Impact Housing ... We have been disappointed by residential investment’s muted response to the significant year-to-date decline in mortgage rates (Chart 5, bottom panel). The trajectory of starts and permits (Chart 5, top panel) hasn’t changed, new and existing home sales haven’t perked up (Chart 5, second panel), and mortgage purchase applications (Chart 5, third panel) appear not to have heard the news that rates are much lower. We thought that the swift fall in mortgage rates would promote more residential investment than it has to date. There is a difference, however, between disappointing growth and a full-on contraction. With affordability remaining high relative to history (Chart 6), and apartment rents exceeding monthly mortgage payments in several locales (Chart 7), housing demand should remain well supported. There are no excesses in the housing market in terms of inventory or oncoming supply that would make housing a source of economic or financial instability. Inventory relative to the number of households is bumping around its all-time lows (Chart 8), and cumulative household formations have easily outstripped housing starts since the crisis broke (Chart 9). Structural factors like a lack of supply geared to first-time and first-move-up buyers, and the ravenous appetite of pools of capital purchasing single-family homes for rent, are squeezing out some would-be buyers, but housing is not about to induce a recession. There are plenty of things for investors to be concerned about, but the housing market isn’t one of them. Chart 6... Though They Have Placed Homeownership In Easier Reach Chart 8... Inventories Are At Record Lows, ... The View From Broad And Wall We concede that stocks are not behaving as if all is well. Big daily swings are not a feature of healthy markets, and eight of this month’s sixteen sessions have registered moves of at least 1%. The second quarter’s 3% year-over-year earnings growth is three percentage points better than the consensus expected when earnings season kicked off, however, and despite the single-day moves, the S&P 500 has spent all but the first day of the month in a well-defined range between 2,825 and 2,945 (Chart 10). The market may be jumpy from one day to the next, but investors have not been concerned enough to engage in sustained selling. The equity market’s verdict on housing is more optimistic than ours. Inspired by earnings reports, the S&P 1500 Homebuilders Index have broken out to a new 52-week high (Chart 11). Retailers were the stars of last week’s earnings releases, with Lowe’s, Nordstrom and Target posting double-digit percentage gains after reporting numbers that failed to live up to investors’ worst fears. Equities are validating the view that the U.S. consumer is alive and kicking. Chart 11Homebuilder Stocks Have Broken Out The GDP Outlook Chart 12Capex Intentions: Elevated But Slipping If consumers are well positioned, the U.S. economy should be, too. Consumption accounts for two-thirds of the U.S. economy, with investment and government spending equally dividing the other third. Federal expenditures amount to about 40% of government spending, and between this year’s fiscal thrust and next year’s hotly contested presidential election, D.C. can be counted upon to do its part for the economy. At the state and local level, healthy household income should support state sales and income tax receipts, while still-rising home prices will provide the property taxes to keep municipal coffers full. That leaves fixed asset investment as the economy’s Achilles heel. We are confident, as noted above, that residential investment will not decline enough to pose a problem for the economy, but corporate investment is in the crosshairs of the uncertainty surrounding the multiple trade squabbles. The NFIB survey and the regional Fed surveys indicate that capital expenditure plans are rolling over, even if they remain at a fairly high level (Chart 12). Our base case remains that investment will not fall enough to offset robust consumption and trend-level government spending, but a marked worsening in trade tensions could erode business confidence enough to drag the economy below stall speed. Busted Thesis In our mutual-fund days, we followed one rule without exception. If our thesis for owning a stock was disproved, we got rid of the stock without a backward glance. We no longer manage money, but our clients do, and we try to set a good example, especially in the inevitable instances when things go wrong. We are closing out our agency mREIT recommendation on the ground that we got the rates call underpinning it very wrong. Things went wrong with our agency mortgage REIT recommendation right from the get-go. In retrospect, we should have waited until the FOMC meeting dust settled before putting on a curve-dependent position. We are closing it out now, though, because we recommended the group in anticipation of a steeper yield curve. Given that we think it will take some time for investors to become convinced that a recession is not imminent, and given that mechanical factors may push yields even lower, we do not expect sustained curve steepening for several months. Although we only held it for four weeks, the recommendation left a mark. Through Thursday’s close, our defined subset of agency mREITs lost 11%, while the S&P 500 is down 3.1% and the Barclays High Yield Index is flat. We’re taking our medicine and moving on, but we will take another look at the group when the curve eventually does begin to steepen. Investment Implications Even if recession fears are overblown, as we and a majority of our colleagues believe, it will likely take some time for investors to overcome their concerns. That leads us to believe that equities may be unable to make new highs in the near term, and that Treasury yields have more downside risk than upside risk in the next few months, as rising convexity2 compels investors following asset-liability management strategies to seek out long-maturity bonds. The yield point may sound complex and esoteric, but our Global Fixed Income Strategy team increasingly believes it’s a key to understanding the negative-yield phenomenon and is researching the issue for an upcoming Special Report. Monetary accommodation is not a silver bullet. If the economy has already flipped from expansion to contraction, modest rate cuts parceled out at a deliberate pace will be insufficient to turn things around, and equities and spread product will suffer. If the expansion remains intact, however, rate cuts will help shore up the economy at the margin and quite possibly fuel a new phase of the bull markets in risk assets. Our money is on the latter, and we expect that this bull cycle has one more burst in it that will allow it to sprint to the finish line like the majority of its predecessors. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Smialek, Jeanna and Russell, Karl, “Rates Are Falling Again. That May Be Dangerous.” New York Times, August 17, 2019, p. B1. 2 Duration measures a bond’s sensitivity to changes in interest rates. Convexity measures duration’s sensitivity to changes in interest rates, which increases as rates fall. Investors like life insurers and pension funds, who match the duration of their investment portfolios with the duration of their liabilities, are forced to increase the duration of their bond holdings at an increasing rate as interest rates fall.

Underweight While insurers have enjoyed a knee jerk rally recently, relative share prices remain in a downtrend, and we recommend fading this run-up. House and auto sales have been in contraction for nearly a year, which bodes ill for insurance profits that have already been struggling to keep pace with the broad market (second panel). This is largely reflected in insurance pricing power, which has barely climbed out from outright deflation (third panel). Bottom Line: Decelerating house and auto sales will continue to weigh on insurers’ pricing power prospects. Stay underweight the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU – CB, MMC, MET, PGR, AON, PRU, AIG, AFL, TRV, ALL, WLTW, HIG, AJG, PFG, CINF, L, LNC, RE, AIZ, GL, UNM. ​​​​​​​

Special Report

Highlights The plunge in government bond yields means that There Is No Alternative to stocks: TINA. As long as bond yields stay reasonably low, stocks will continue to climb the proverbial wall of worry. Global equities are quite cheap compared with bonds. This suggests that stock market returns could be quite strong over the next couple of years, as PE multiples rise in order to narrow the gap between bond yields and earnings yields. While cheap in relative terms, global equities are modestly expensive in absolute terms. Thus, long-term absolute stock market returns are likely to be subpar, even if they are reasonably high in the near term. U.S. stocks are noticeably more expensive than their overseas peers. Differences in sector composition can explain some of the valuation gap, but not all of it. We intend to upgrade EM and European stocks later this year once global growth begins to reaccelerate. Feature Falling Bond Yields Have Made Stocks More Attractive After peaking last year, global bond yields have plunged anew (Chart 1). To a large extent, the decline in yields has been driven by the slowdown in global growth. Chart 2 shows that there is a strong correlation between government bond yields and manufacturing purchasing manager indices. Chart 1Global Bond Yields Sinking Chart 2The Decline In Bond Yields Driven By Slower Global Growth   Chart 3Dividend Yields Are Higher Than Bond Yields Globally As we discussed last week, global growth should stabilize and recover over the remainder of the year, which will cause bond yields to move somewhat higher. Nevertheless, yields are poised to stay low by historic standards – at least until inflation picks up significantly, which is unlikely to occur during the next 12 months. The fact that government bond yields in many countries are negative in real terms – and indeed, negative in nominal terms in Japan and across much of Europe – implies that the only way investors can hope to generate decent returns is by taking on more risk. This means moving further down the quality ladder in the fixed-income space, as well as turning to historically riskier asset classes such as equities. The allure that equities have in today’s low rate environment even has a name: TINA – There Is No Alternative. The S&P 500 dividend yield is currently 1.98%, 37 bps above the yield on 10-year Treasury notes. To put things in perspective, even if S&P 500 companies did not increase cash dividends at all for the next ten years, the real value of the index would still have to fall by 26% (assuming 2% inflation) for bonds to outperform stocks. The gap between dividend yields and bond yields is even greater abroad (Chart 3).   TINA’s Critics That may seem like a very low bar for success, but there are plenty of prognosticators who think stocks will still fail to clear it. TINA’s detractors offer two arguments to justify their skepticism: Today’s low interest rates are simply a reflection of poor economic growth prospects. Even if one believed that lower interest rates warrant higher equity multiples, the stock market has already priced that in. John Hussman eloquently summarized these arguments in a recent report: Another danger for investors here is the willingness to accept offensively speculative valuations on the argument that bond yields are low. The empirical fact is that bond yields are tightly correlated with nominal GDP growth. But as one can demonstrate using any discounted cash flow model, if interest rates are low because growth rates are also low, no valuation premium is “justified” by the low interest rates at all. Long-term returns will already be lower, commensurate with the lower interest rates, by virtue of the lower growth rate itself. A valuation premium then just adds insult to injury.           – John Hussman, “Questions we hear a lot,” Hussman Market Comment, (January 2019). John Hussman is a perspicuous market observer, but there are two flaws in his logic here. The first one is factual. Despite his claim to the contrary, U.S. bond yields have actually fallen more than trend nominal GDP growth over the past decade (Chart 4). The current gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is over two percentage points, the highest since 1979. Chart 4Bond Yields Have Fallen More Than Trend Nominal GDP Growth Chart 5The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM At the global level, trend GDP growth has barely changed, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 5). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure. If trend global GDP growth has not fallen, why are real interest rates so low? The answer is that the world is still awash with savings. As Chart 6 illustrates, an increase in desired savings will lead to a decline in real rates, even if underlying growth does not change.   No Free Lunch The second error is more subtle. Hussman discusses earnings growth and GDP growth as though they are one in the same. However, there is no long-term mechanism that magically bestows faster earnings growth on firms just because trend economic growth accelerates. Earnings growth and GDP growth are tightly correlated over the course of a business cycle because rising demand allows firms to spread fixed costs over a larger amount of output, thus increasing so-called operational leverage. But if a firm wishes to grow earnings over the long run, it has to invest in new technology and new capacity. That takes real resources — resources that could otherwise be distributed to shareholders. An example might clarify this point. Consider two firms, each with a market value of $1 million and $100,000 in earnings. Firm A distributes all its earnings to shareholders in the form of dividends. Firm B pays no dividend. Rather, it invests all its earnings in trying to grow the business. Which firm would you rather own? There is actually no simple answer to this question. If you invest in Firm A and the share price remains unchanged because the company has done nothing to grow its business, you will still receive a 10% dividend yield. You will not receive a dividend by investing in Firm B. However, if the company is able to grow earnings by 10% and the price-earnings ratio remains unchanged, the share price will rise by 10%. In both cases, you make a 10% return. The point is that there is no free lunch. Firms in fast-growing economies will be able to avail themselves of expanding domestic markets, but they will need to spend money to grow their businesses. They are also likely to face stiffer competition from new entrants. This is a key reason why Jay Ritter and other economists have shown that there is no clear correlation between long-term economic growth and shareholder returns (Chart 7). Priced For Perfection? One thing that Hussman gets completely right is that absolute long-term equity returns depend on the absolute level of valuations rather than how expensive stocks are in relation to bonds. A decline in the discount rate will increase the present value of future earnings, thus leading to a temporary period of abnormally high returns. However, once equity valuations have reset to a higher level, returns will be permanently lower. In other words, falling interest rates simply shift returns from the future into the present (Chart 8). The key question for investors is where we are in this process. If stock valuations have yet to fully adjust to the decline in interest rates, near-term returns could still be quite strong, even if they do come at the expense of subsequent returns. There is good reason to think this adjustment has yet to play out fully. The forward PE ratio for U.S. stocks is currently 16.5. If one were to use the earnings yield as a proxy for expected returns (see Appendix A for details), one would expect U.S. equities to generate long-term annualized real total returns of 6.1%. Outside the U.S., the forward PE ratio stands at 12.7, implying an expected return of 7.8% (Chart 9). Chart 10 shows that the equity risk premium in the U.S. based on the forward PE ratio remains quite high, indicating that the earnings yield has not fallen as much as one would have expected based on the decline in real bond yields. The equity risk premium is even higher outside the U.S., reflecting both the fact that valuations are cheaper abroad and interest rates are generally lower. Chart 10AEquity Risk Premia Remain Quite High (I) Chart 10BEquity Risk Premia Remain Quite High (II)   Are PE Ratios Biased Down? One legitimate criticism of the forward PE ratio is that it relies on analyst earnings estimates, which tend to be too optimistic. That analysts tend to be too bullish is undeniable (Chart 11). However, even if one were to use the trailing PE ratio, the implied long-term expected real total return would still be 4.8% in the U.S. and 7.1% abroad. Chart 11Analysts Are Usually Too Optimistic Moreover, as Chart 12 illustrates, projected 12-month earnings growth is currently below its historic average both in the U.S. and abroad. Thus, to the extent that forward PE ratios are biased downwards, that bias is arguably smaller than in the past. Chart 12Earnings Growth Estimates Are Not Excessive Today Chart 13Cyclically-Adjusted PEs Point To Subpar Absolute Future Returns   A further criticism of both trailing and forward PE ratios is that they do not take into account cyclical factors that could either flatter or depress earnings. For example, if profit margins are temporarily inflated, standard PE ratios will tend to show that stocks are cheaper than they really are. One way to address this issue is to use a moving average for earnings. The most popular tool for doing so is the Shiller PE ratio (also known as the cyclically-adjusted PE ratio, or CAPE). It divides the value of today’s stock market index by the average of real earnings over the past ten years. The Shiller PE ratio currently points to below-average, but still positive, real returns for stocks over the coming years (Chart 13). S&P 500 Margins Versus Economy-Wide Margins Some stock market bears charge that the Shiller PE ratio does not go far enough in eliminating the upward bias to earnings. They point out that even though S&P 500 profit margins were very depressed following the Global Financial Crisis, the 10-year average of margins is now well above its historic norm (Chart 14). Chart 14U.S.: 10-Year Average Of Margins Is Now Well Above Its Historic Norm John Hussman’s preferred measure, the Margin-Adjusted PE ratio, tries to control for this alleged problem by adjusting earnings using the economy-wide profit-to-GDP ratio. It suggests that future returns will be lower than those implied by the Shiller PE ratio. The problem with Hussman’s approach is that S&P 500 profits have increasingly become disconnected from economy-wide profits. Chart 15 shows that pre-tax profits have trended lower as a share of GDP in recent years, a move that has been mirrored in the rise in employee compensation. However, no such decline has occurred for S&P 500 profits. Chart 15The Recent Decline In U.S. Pre-Tax Profits Has Been Mirrored In The Rise In Employee Compensation Chart 16S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500 margins have stayed elevated partly because U.S. multinationals are less exposed to domestic wage pressures. Margins have also been propped up by the fact that the largest companies in the index increasingly operate like natural monopolies. It is perhaps no surprise that all of the increase in S&P 500 margins over the past few decades has been due to soaring profits in the IT sector (Chart 16). If this represents a true structural change, S&P margins could remain high by historic standards. Investment Implications Different valuation measures can generate different results. As such, we would not get too hung up on the precise expected return forecast that any one particular valuation indicator produces. Appendix B shows long-term return projections for various stock markets using a composite valuation measure based on price-to-trailing earnings, price-to-forward earnings, price-to-cash flow, price-to-sales, price-to-book, Tobin’s Q, stock market capitalization-to-GDP, and dividend yield. Three broad conclusions stand out: First, global equities are quite cheap compared with bonds. This suggests that stock market returns could be quite strong over the next couple of years, as PE multiples rise in order to narrow the gap between bond yields and earnings yields. We recommend that asset allocators overweight stocks relative to government bonds on a 12-to-18 month horizon. Second, global equities are modestly expensive in absolute terms. Thus, long-term stock market returns are likely to be subpar, even if they are reasonably high in the near term. Put differently, while equities will trump bonds over the long haul, both asset classes will deliver uninspiring absolute returns compared with their long-term history. Third, U.S. stocks are noticeably more expensive than their overseas peers. Differences in sector composition can explain some of the valuation gap, but not all of it. As Chart 17 illustrates, if one were to calculate the forward PE of say, European stocks, using U.S. sector weights, the former would still be significantly cheaper than the latter. We intend to upgrade EM and European stocks later this year once global growth begins to reaccelerate.   APPENDIX A The Earnings Yield As A Proxy For Expected Shareholder Returns  APPENDIX B CHART 1 Equities: Composite Valuation Indicators Versus Subsequent 10-Year Real Annualized Returns Peter Berezin,  Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com MacroQuant Model And Current Subjective Scores  

Special Report

Dear Client, Please note that there will be no regular Weekly Report next week, as we take a summer break. Our regular publication will resume September 6th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights Our PPP models show the DXY index to be overvalued by 10-15%. Within the G10 universe, the cheapest currencies are the Swedish krona, the British pound, the Japanese yen and the Norwegian krone. Look to go short CHF/GBP on valuation grounds. Feature Regular readers of our publication will notice that we tend to adhere to very simple and time-tested ideas. One such is the concept of purchasing power parity (PPP). The beauty comes from its simplicity. If the price of a good in Sweden is rising faster than in South Africa, then the krona should depreciate versus the rand to equalize prices across both borders. Otherwise, the krona becomes incrementally expensive, relative to the rand. In practice, various models have shown PPP to be a very poor tool for managing currencies. One roadblock comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. Second, there is less price discovery for services, than there is for tradable goods. For example, it is rather difficult to import a haircut from Mumbai into the U.S., and so arbitraging those prices away tends to be impractical. Tariffs, trade restrictions and transport costs also tend to dampen the explanatory power of PPP models, though those have had diminishing importance over time. In order to get closer to an apples-to-apples comparison across countries, we make two adjustments. First, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: Food, restaurants and hotels Shelter Health, culture and recreation Energy and transportation Household goods The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If for example, shelter is 33% in the U.S. CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. The results were largely consistent: Both regressions were statistically significant, but more so for REG1. This makes intuitive sense, as the number of variables were higher in the first regression. The sign for household goods was negative for some countries. This could be due to some specter of multicollinearity, if the tradable goods price effect is captured in other categories. There is also the low value-to-weight ratio for many household goods such as refrigerators or air conditioners, which could make currency deviations from PPP persistent. The shelter sign was also negative for some countries, meaning rising shelter prices tended to be associated with an incrementally cheaper currency. This could be due to the Balassa-Samuelson effect. Rising incomes (one key determinant of rising house prices) usually reflect rising productivity levels, which tend to lift the fair value of the exchange rate. The results showed the U.S. dollar as overvalued, especially versus the Swedish krona, British pound and Norwegian krone. Commodity currencies were closer to fair value, and within the safe haven complex, the Japanese yen was more attractive than the Swiss franc. The euro was less undervalued than implied by the overvaluation in the DXY index. As a final note, PPP models are just an additional kit to our currency toolbox, and so should never be used in isolation, but in conjunction with other currency signals. This is just a first iteration in our PPP modelling work, which we intend to improve in the months to come. U.S. Dollar We reverse-engineered the fair value for the DXY index by aggregating the model results from its six constituents. This includes the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc, using the corresponding DXY weights. The message from the synthetic model is clear: the U.S dollar is above its fair value, in line with our fundamental view (Chart 1). Chart 1The Dollar is Slightly Expensive Americans spent 35% of their income in 2018 on goods and 65% on services. Shelter remains the single largest consumption item for American households, which makes up 33% of the consumption basket. However, the relative importance of shelter is dwarfed by much more rampant rent and house price increases in other developed countries. Medical care accounts for 8.7% of the CPI basket, and is the highest in the developed world on a per capita basis. Total spending on health care accounts for almost 20% of nominal GDP. Since the 1980s, the CPI for medical care has risen fivefold, far outpacing many developed countries. This makes the dollar incrementally expensive.  Core CPI edged higher to 2.2% in July, driven by medical care and shelter. While above the Federal Reserve’s 2% target, the risks to inflation remain asymmetric to the downside. That will keep the Fed on a dovish path near-term, which should help close overvaluation in the dollar. Euro We had limited data for the euro area, and so our regression results were less robust. REG1 shows the euro as cheap, while REG2 is more ambiguous (Chart 2). In short, a PPP model for the euro had one of lowest explanatory powers within the G10 universe. Food, restaurants and hotels are the largest consumption item in the euro CPI basket. Looking at the details, food and non-alcoholic beverages account for 14%, alcohol and tobacco make up 4%, and restaurant and hotels account for about 10% (Table). Relative price trends have moved to undermine the fair value of the euro. Chart 2The Euro Is Slightly Cheap Euro Area CPI Weights Shelter’s weight in the euro area CPI basket currently stands at 16.7%, the smallest among G10 countries. Since 2012, relative house and rent prices in the euro area have been decreasing compared with that in the U.S. Rampant rent controls, especially in places like Germany have subdued housing CPI, and tempered the fair value of the euro. This makes sense to the extent that it represents a concomitant rise in the welfare state. It is well-known that the euro area is relatively open and so tradable goods prices are important for the fair value of the euro. Given that the epicenter of trade tensions is between the U.S. and China, this will act to boost the relative attractiveness of European goods, which will be a bullish underpinning for the euro. Inflation expectations have collapsed in the euro area. However, compared to the Federal Reserve, there is little the European Central Bank can do to boost inflation. This is relatively euro bullish. Once global growth eventually picks up, improved competitiveness in the periphery will allow for non-inflationary growth. Japanese Yen The yen benefits from being cheap, as well as being a safe-haven currency (Chart 3). The overarching theme for Japan is a falling (and rapidly aging) population, which means that deficient demand and falling prices are the norm. This makes the yen relatively attractive on a recurring basis. Most of the Heisei era in Japan has been characterized by deflation. Importantly, all categories in Japan have been in a relative price downtrend during this period (Table). Domestically, an aging population (that tends to be a large voting base), prefer falling prices. Meanwhile, the bursting of the asset bubble in the late 80s/early 90s led to a powerful deleveraging wave that undermined prices. Chart 3The Yen Is Quite Cheap Japan CPI Weights The relative prices for most items have been decreasing, but culture and recreation inflation have experienced a meaningful rebound since 2013, largely due to a booming tourism industry in Japan.1 According to tourism statistics, the number of international visitors to Japan reached 31 million in 2018, almost five times the number ten years ago. But as long as the younger generation in Japan continues to save more and consume less, prices will remain under pressure. BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, but inflation expectations are falling to historical lows at a time when the BoJ is running out of policy bullets.2  That means inflation will likely lag that of other developed countries, lifting the fair value of the yen. British Pound Both regressions show the pound as undervalued. This supports our view that over the long term, the pound is a categorical buy (Chart 4). The consumption baskets in both the U.K. and the U.S. are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials (Table). For example, OECD PPP models, based on national expenditure, show the pound as 15% undervalued. Chart 4The Pound Is Cheap U.K. CPI Weights Housing is the largest item in the consumption basket, with a total weight close to 30% (including housing electricity and water supply). The shelter consumer price index in the U.K. started to fall relative to the U.S. in 2016, which has lowered the fair-value of the pound (in the Balassa-Samuelson framework). That said, the fall in the pound has been much more deep and violent than suggested by domestic price fundamentals. For example, food restaurants and hotels are 10% cheaper in the U.K. compared to the U.S. over the last half decade. However, rather than appreciating 10%, the pound has plummeted by about 30%. Brexit will continue to dictate the ebb and flow of sterling gyrations, but the reality is that the pound should be higher on a fundamental basis. Meanwhile, a pick up in the global economy will benefit the pound. Going short CHF/GBP on valuation grounds is an attractive bet today. Australian Dollar As a commodity currency, PPP models are less useful for the Australian dollar than terms of trade, or even interest rate differentials. That said, the Aussie dollar is still relatively cheap versus the USD on a PPP basis (Chart 5). The key driver for value in the AUD has been a drop in the currency, relative to what price differentials will dictate. Food, restaurants and hotels comprise 23% of the Australian CPI basket, with the alcohol and tobacco category alone making up 7.4% (Table). Given food price differentials have been stable versus the U.S. in over a decade, Aussie citizens have not been particularly worse off. Chart 5The Aussie Is Slightly Cheap Australia CPI Weights Shelter accounts for almost a quarter percent of the basket. Relative shelter prices in Australia have been rising since the late 1990s, but started to soften in the past few years, on the back of macro prudential measures. Meanwhile, holiday travel and accommodation have a total weight of 6%, of which domestic travel makes up 2.9%, and international travel 3.1%. The overall cost of tourism in Australia has been falling relative to the U.S., boosting the fair value of the Aussie. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, but more by RBA policy and terms of trade. New Zealand Dollar The New Zealand dollar is at fair value according to both models (Chart 6).  Like the aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have not been moving in favor of the kiwi (Table). So, while the kiwi was overvalued earlier this decade, the overvaluation gap has been mostly closed via a higher dollar. Chart 6The Kiwi Is At Fair Value New Zealand CPI Weights Relative shelter prices in New Zealand have been soaring in recent decades compared to the U.S. Higher immigration, foreign purchases and a commodity boom helped. However, in August 2018, the ban on foreign property purchases came into effect, which helped cool down the housing market. Like in Australia, the inflation rate in New Zealand reached 18% year-on-year in the early 1980s, and was subsequently addressed via inflation targeting. This has realigned New Zealand prices somewhat with the rest of the world. Our bias is that going forward, the kiwi will underperform the aussie, mainly because of a negative terms of trade shock. Canadian Dollar The loonie is currently trading below its fair value, according to both of our models (Chart 7).  Shelter remains the largest budget item for Canadian households (Table). The average Canadian household spent C$18,637 on shelter per year, around 29.2% of the total consumption in 2017.3 Interestingly, the shelter consumer price index does not fully capture skyrocketing house prices in Canada over the last decade. Since 2005, Canadian house prices relative to U.S. have doubled, according to OECD. On the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the explanatory power of the exchange rate. Chart 7The Loonie Is Slightly Cheap Canada CPI Weights Canadians are avid users of private transportation. The average spending on transportation accounted for 20% of total consumption, the second-largest expenditure item. Relative prices in this category have been rising, which has lowered the fair value of the exchange rate. Canada stands as the sixth largest energy producer in the world, but due to heavy taxation, Canadian consumers are paying more for gas prices than their U.S. neighbors. That said, terms of trade have been more important than PPP concerns for the loonie. In the near term, we believe energy prices (and the Western Canadian Select price spread) will continue to be important for the loonie. Swiss Franc USD/CHF is trading slightly below fair value, despite structural appreciation in the franc in recent years (Chart 8). The largest consumption item in Switzerland is the food, restaurants and hotels category (Table). The second item is shelter. Social services have a higher weight in the CPI basket, compared to other developed nations. This has been a huge driver of relative prices between Switzerland and the rest of the world, with falling relative prices boosting the fair value of the franc. Chart 8The Swiss Franc Is At Fair Value Switzerland CPI Weights Healthcare notably accounts for 15.5% in the total CPI basket, of which patient services makes up 11.5%. The Swiss healthcare system is a combination of public, subsidized private, and entirely private systems. It is mandatory for a Swiss resident to purchase basic health insurance, which covers a range of treatments. The insured person then pays the insurance premium plus part of the treatment costs. Finally, as a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are soaring to record highs. This makes the franc a core holding in a currency portfolio. Norwegian Krone The Norwegian krone is undervalued according to both models (Chart 9). Food and shelter account for the largest share of the Norwegian CPI basket (Table). While the share of shelter is lower than in the U.S., other categories share similar weights, allowing traditional PPP models to be adequate for USD/NOK. One difference is that in terms of social services, only 0.2% of the expenditures are allocated to education, since all schools are free in Norway, including universities. Chart 9The Norwegian Krone Is Cheap Norway CPI Weights As a large energy producer, Norwegians pay less for electricity, gas, and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices. Going forward, the path of energy prices will continue to dictate ebbs and flows in the krone. Meanwhile, long NOK positions also benefit from an attractive valuation starting point.  Swedish Krona The krona is the cheapest currency in our universe by a wide margin (Chart 10). This stems less from fluctuations in relative prices and more from negative rates that have hammered the exchange rate. Like many countries, food and shelter is the largest component of the consumption basket (Table). Transportation is also important. However, an important driver for undervaluation in the currency has been a drop in the relative price of social services. Chart 10The Swedish Krona Is Very Cheap Sweden CPI Weights Sweden experienced very high inflation rates in the 1980s, and since then, has been in a disinflationary regime. More recently, the inflation rate has edged down below the Riksbank’s target, mostly dragged down by recreation, culture, and healthcare. This makes Swedish real rates relatively attractive. We remain positive on the Swedish krona and believe that it will be one of the first to benefit, should global growth pick up.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com   Kelly Zhong, Research Analyst kellyz@bcaresearch.com Footnotes 1 We removed the shelter component in regression 1, since it was distorting results. 2 Please see Foreign Exchange Strategy Weekly Report, titled “Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much”, dated May 31, 2019, available at fes.bcaresearch.com 3 Please see “Survey of Household Spending, 2017,” Statistic Canada, December 12, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights The chance of a U.S.-China trade agreement is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities. Feature “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart 1). Chart 1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart 2) – an actual recession would consign him to the dustbin of history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart 3). This leaves him less room for maneuver going forward. Chart 3China's Gradual Stimulus Yet To Revive Global Economy Chart 4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart 4).   Q4 may be Trump’s last chance to save the business cycle and his presidency. The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart 5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart 6). Chart 5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. Chart 7Trump's Fiscal Policy Undid His Trade Policy In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart 7). The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop, given that its economy is still closely linked to the rest of the world (Chart 8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart 8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.1 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,2 and will the outcome derail the trade talks? Bottom Line: Global economic growth is fragile and President Trump has only tentatively retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table 1). Many of these concessions have been postponed as a result of Trump’s punitive measures. Table 1China’s Offers Thus Far In The Trade War It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “balance” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. The threat of a divorce from the U.S. is a danger to China’s economy and the Communist regime. Chart 9China's Ultimate Economic Constraint Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart 9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart 10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Chart 10Creative Destruction In China Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart 11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart 11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram 1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Diagram 1The South China Sea As The World’s Traffic Roundabout Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart 12A & 12B). A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart 13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart 14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart 14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. Chart 15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart 15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart 16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart 17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart 18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature. Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart 19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time. While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart 20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart 21). This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Taiwan has a lot more dry powder for a political crisis than Hong Kong. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart 22). A deterioration in this region has global consequences. Chart 22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward. Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 2 Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory.

Highlights Today’s equity risk premium of 1.6 percent makes equities the preferred long-term asset-class versus bonds at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly. German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. We closed our tactical short in equities at its 4 percent profit-target, and are now tactically neutral. Fractal analysis suggests that bonds are now technically overbought… …but developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Feature Chart of the WeekStocks Set To Return 3 Percent, Bonds Set To Return 1.4 Percent Bonds Set To Return 1.4 Percent This year’s rally in bonds has dragged down bond yields to unprecedented lows. Indeed, in many markets, the term ‘bond return’ should more truthfully be called ‘bond penalty’. For example, with the German 10-year bund now yielding -0.7 percent, buying and holding it for its ten year life will lose you 7 percent of your money.1 Or will it? Unlike in most jurisdictions where the currency cannot disintegrate, euro area bond yields are complicated by ‘redenomination’ discounts and premiums. If you were certain that the euro was going to break up within the next ten years, and that the German bund would pay you back in new deutschmarks worth 7 percent more than euros, then the currency redenomination gain would more than cancel out the cumulative loss from the negative yield. For this reason a better measure of the euro area bond yield comes from the single currency bloc’s average yield – because in a break up, the expected currency gains and losses for the average euro area bond yield must sum to zero. To avoid the onerous calculation of this euro area average yield, a useful proxy turns out to be the French OAT yield. While not as depressed as the German bund yield, the 10-year OAT yield, at -0.35 percent, still constitutes a bond penalty (Chart I-2). The global bond yield has reached a new record low. Meanwhile, although the global 10-year bond yield is still positive, it recently fell to an all-time low of 1.40 percent – breaking the previous record low of 1.43 percent set in the aftermath of the 2016 shock vote for Brexit (Chart I-3). Chart I-2The French OAT Is A Good Proxy For The Average Euro Area Bond Chart I-3Bonds Set To Return##br## 1.4 Percent Stocks Set To Return 3 Percent    The long term prospective return from most asset-classes is well-defined: for the bond asset-class it is the yield to maturity, now at 1.4 percent;2 for the equity asset-class it comes from the starting valuation, which tends to be an excellent predictor of the long term prospective return. But which valuation metric? Equity valuations based on earnings are problematic – because valuations appear deceptively attractive when profit margins are structurally high, as they are now (Chart I-4). The problem is that earnings will face a structural headwind when margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this only corrects for the cycle and does not correct for any structural trend. Chart I-4Structurally High Profit Margins Flatter Equity Earnings Equity valuations based on assets are also problematic. Nowadays, such assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to quantify accurately. Hence, our preferred long-term valuation metric is price to sales – because sales are quantifiable, objective, and unambiguous. Indeed, the starting price to sales multiple of the global equity asset-class has been a near-perfect predictor of its prospective 10-year nominal return (Chart I-5). The method is to regress historic starting price to sales with (the known) prospective 10-year returns. Then apply the established relationship to the current price to sales to predict the (the unknown) prospective return. Chart I-5Stocks Set To Return 3 Percent On this basis, today’s prospective 10-year annualised return from global equities is 3 percent.  Is The 1.6 Percent Excess Return Enough? So the prospective 10-year return from equities, at an annualised 3 percent, is 1.6 percent more than that from bonds, at 1.4 percent.3 Is this excess return – the so-called ‘equity risk premium’ – enough (Chart of the Week)? Price to sales has been a near-perfect predictor of long term equity returns.   Yes, because at ultra-low bond yields, the risk of owning bonds converges with the risk of owning equities. The asymmetry in the future direction of bond yields makes bonds riskier investments. The short-term potential for capital appreciation – nominal or real – diminishes, while the potential for vicious losses increases dramatically. The technical term for this unattractive asymmetry is negative skew. Recent breakthroughs in risk theory and behavioural economics conclude that our perception of an investment’s risk does not come from its volatility or correlation characteristics. It comes from the investment’s negative skew. The upshot is that today’s excess prospective return of 1.6 percent does make equities the preferred long-term asset-class at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly (Chart I-6). Interestingly, German equities are an excellent long-term proxy for global equities, producing near-identical returns (Chart I-7). This is not surprising given the very similar international and sector focusses. We can infer that the German stock market, just like the global equity asset-class, is set to deliver an annualised 10-year return of 3 percent. But in Germany, the 10-year bond yield is -0.7 percent, implying that German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. Chart I-7German Equities Are An Excellent Proxy For Global Equities Some Other Asset Allocation Thoughts The rally in bonds has hurt our cyclical overweight to the DAX versus long-dated German bunds. However, given the aforementioned long-term analysis, we are sticking with it, albeit switching it from a cyclical to a structural recommendation. Our other recent asset allocation recommendations have worked. In May, we pointed out that the simultaneous strong rallies in equities, bonds, and oil was extremely rare, and that at least one of the rallies would soon break down. This is precisely what happened. While bonds rallied a further 5 percent, equities corrected by 5 percent, and the crude oil price plunged 20 percent. However, our portfolio construction could have been better as our weightings in the three assets left the combined short position roughly flat. The position is now closed. Our tactical short in equities achieved its 4 percent profit-target. Likewise in June, fractal analysis suggested that the double-digit rally in stock markets was vulnerable to a countertrend reversal. This is precisely what happened. Our tactical short position in the MSCI AC World Index achieved its 4 percent profit-target and is now closed (Chart I-8). Stay tactically neutral to equities. Chart I-8Stocks Were Overbought, And Reversed Interestingly, the same fractal analysis is suggesting that it is the stellar rally in bonds that is now vulnerable to a countertrend reversal (Chart I-9), implying a tactical short position in bonds. Having said that, developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Chart I-9Bonds Are Overbought Fractal Trading System* This week we note that the sharp underperformance of Spain (IBEX 35) versus Belgium (BEL 20) is technically extended and susceptible to a liquidity-triggered reversal. Accordingly, the recommended trade is to go long Spain versus Belgium setting a profit-target of 3.5 percent with a symmetrical stop-loss. In the other trades, short MSCI All-Country World achieved its 4 percent profit-target and is now closed. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no default risk and no reinvestment risk. 2 Assuming no default risk and no reinvestment risk. 3 Nominal annualised total return, capital plus income. 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