Developed Countries

Overweight 2018 has been a tough year for the S&P industrial conglomerates index as all of the key constituent members (GE, MMM and HON) have progressively either disappointed on earnings or lowered forward guidance. Further, industrial dividend stalwart GE yesterday took their dividend down to $0.01 per share, effectively suspending the dividend while the company refocuses its businesses and deleverages. The market’s reaction to the forgoing has been brutal, taking the sector down to relative levels lower than the deepest depths of the financial crisis (recall that GE was, at the time, one of the largest lenders in the U.S.). We think this is an overreaction; our Valuation Indicator is now more than one standard deviation below fair value while our Technical Indicator is extraordinarily oversold, a position that has heralded mean reversions in the past. Bottom Line: In the absence of any confirming data supporting such draconian valuation moves on already record-low EPS growth estimates, we believe a window for solid value at exceptional prices has opened. Accordingly, today we are lifting our recommendation on the S&P industrial conglomerates index to overweight from neutral. This move preserves our overweight recommendation on the GICS 1 S&P industrials index, given our downgrade of the S&P railroads index earlier this week.1 The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. 1 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset,” dated October 29, 2018, available at uses.bcaresearch.com.

Special Report

Highlights So What? The bull market in defense stocks is global and only beginning. We construct a BCA Global Defense Index to give investors exposure to this theme. Why? Multipolarity will drive uncertainty and conflict, spurring arms demand to Cold War heights. Contemporary geopolitical hotspots require expensive and modern technology. Cold War-era weapon systems are long in the tooth and in need of replacement. Also... We close our long Energy / short S&P 500 portfolio hedge for a gain. Feature It is somewhat of a cliché to tell clients that one of our highest conviction calls is to be overweight defense stocks. We are, after all, geopolitical investment strategists! Our decision to go long S&P 500 aerospace and defense stocks / short MSCI ACW is up 14% since initiation in December 2016. In this report, we build on previous work focusing on U.S. defense stocks and expand our analysis to global plays. GPS' Mega-Theme: Multipolarity Is Good For War International affairs are characterized by an anarchic governance structure. In the absence of a global government, the vacuum of power is filled by powerful states. These states behave like bullies in the schoolyard. When a single, powerful bully dominates the lunch break, all other kids fall in line or suffer the bully's wrath. When two bullies split the yard into warring camps, proxy fights may emerge on the sidelines, but generally an equilibrium is preserved. Formal political science theory and history teach us that the further we are from a hegemonic global structure where one country (the hegemon) dominates and bullies all others, the closer we are to anarchy. The "offensive realism" school of International Relations theory further splits multipolarity into two types: Balanced multipolarity is characterized by a number of roughly equally powerful states, similar to the distribution of power of continental Europe during the "Concert of Europe" era in the nineteenth century. Unbalanced multipolarity is closest to contemporary geopolitics. In The Tragedy Of Great Power Politics, John Mearsheimer reviewed 200 years of European history and concluded that unbalanced multipolarity is by far the most volatile geopolitical system (Table 1).1 Table 1Global System Structure And War A multipolar ordering of global power, therefore, produces the highest level of disorder (Chart 1). This finding is theoretically elegant, but normatively disturbing. Every country gets a voice and an opportunity to defend its sovereignty. But the international order is normatively ignorant and desires a bully or hegemon. Chart 1Multipolarity Produces Disorder Over the past fifty years, there have been three identifiable periods in the global arms market (Chart 2): Chart 2Further Upside In The 'War Bull Market' Cold War Arms Race - 1961-1982: The arms trade grew by a whopping 177% during this period, with an average annual growth rate of 5.5%; Disarmament - 1982-2002: Arms trade shrunk by 61% and average annual growth rate was -3.9%; Multipolarity - 2002-present: What started with the U.S. defense buildup following 9/11 has evolved into a truly global response to emerging multipolarity. The arms trade grew by 73% from 2002 to 2017, with an average annual growth rate of 3.4%. Bottom Line: In 2017, the total arms trade was 68% of its peak in 1982, signifying that we have more room to go in this recent "War Bull Market." Given that unbalanced multipolarity produces a higher volume of conflict than a bipolar system, we would expect the current phase to be more fruitful for the global arms race than even the Cold War era. The Pillars Of An Arms Bull Market Chart 3Global Defense Spending... In this report, we focus on the global arms trade, which is different from global defense spending (Chart 3). This is because global defense spending includes non-investible transactions, such as spending on salaries, buildings, health care, and pensions. The global arms trade was once 20% of global defense spending, but is now only 1.9% (Chart 4). Chart 4...Is Different From The Global Arms Trade The reason is that salaries and pensions now dominate defense budgets. In the U.S., they make up 42% of all expenditure. They are higher in much of the developed world (66% in Italy, for example). Moreover, many countries that in 1960 did not have an armaments industry have become quite adept at satisfying demand via domestic production. We nonetheless would expect the global arms trade to bounce off of its lows today. There are three main reasons. Evolving Conflict Zones: Asia And Europe The primary reason to expect a brisk pickup in the global arms race is that the global conflict zones are evolving. Multipolarity is causing shifting geopolitical equilibriums. We expect both East Asia and Europe - largely dormant as hotspots since the end of the Cold War - to catch up with the Middle East as zones of tensions. Periods of rising conflict tend to coincide with the rise in the global arms trade (Chart 5). Chart 5Rising Conflict Coincides With Escalating Arms Trade East Asia is our primary concern. Sino-American tensions have been brewing for decades, well before the trade war initiated by the Trump administration. Recently, the trade war has begun to spill into strategic areas (Table 2), creating a vicious feedback loop that could spark an accident or outright military conflict. Table 2Trade War Spills Into Strategic Areas The South China Sea is the premier geographic location of U.S.-China strategic friction. It is a hub for international trade, a vital supply route for all major Asian economies, and the premier focus of China's attempt to rewrite global rules (Diagram 1). We update our list of clashes in this area in Appendix A. Diagram 1South China Sea As Traffic Roundabout China has used its growing economic heft in the region to bully its neighbors into acquiescing to its geopolitical posture (Chart 6). It has used economic sanctions, trade boycotts, and tourism bans to get its way with the neighborhood. China's East Asia neighbors - including Japan - will look to balance their growing dependence on the Chinese economy with a desire to maintain sovereignty. One way to do so will be to rearm and present a formidable challenge to Beijing's regional hegemony. This means that not only the South China Sea but also China's entire periphery is at risk of friction, and this is true regardless of any U.S. interest in Asia. Chart 6China Uses Its Economic Might To Bully Europe is also growing as a potential source of global arms demand. Since the end of the Cold War, Europe has seen a decline in defense spending. One reason is the NATO alliance, which has allowed Europeans to pass the buck to the U.S. This has not only been the case with the safely cocooned Western European states. Poland, intimately familiar with the built-in geopolitical risks of its neighborhood, reduced its defense spending once it joined NATO. President Trump has made awakening Europe from its stupor a key pillar of his trans-Atlantic policy. A combination of Trump's pestering and concerns that the U.S. is trending towards isolationism with an evolving threat matrix that now includes terrorism, migration, and Russia should be enough to spur Europeans to meet their commitment to spend 2% of GDP on defense (Chart 7). Chart 7Europeans Will Be Swayed To Meet Defense Commitments... If NATO member states and Japan were to respond to their evolving threats and commit to spending 2% of GDP on defense, the impact on global arms demand would be significant. The extra spending would be roughly $145 billion, a 14% increase from current levels (Chart 8). Chart 8...Raising Global Arms Demand What about the Middle East? In the short term, we are concerned that President Trump's "maximum pressure" policy could lead to kinetic action against Iran. In the medium and long term, we expect some form of an equilibrium to emerge in the Middle East that would keep regional demand for weapons stable at current elevated levels. Saudi Arabia has been the primary importer of weapons, with 13% of total demand since 2002. Saudi purchases have accelerated as the U.S. has geopolitically deleveraged out of the region (Chart 9 and Chart 10). Chart 9As The U.S. Military Deleverages... Chart 10...The Saudi Arabian Military Leverages Evolving Technological Demands The U.S. invasion of Afghanistan and Iraq at the beginning of this century was probably the last large-scale mechanized conflict involving large formations of main battle tanks (MBT). The evolving threat matrixes in East Asia and Europe are likely to create a growing demand for naval, air superiority, and drone/autonomous technology. In East Asia, the two main risk theaters are the South and East China Seas. In Europe, the Mediterranean, the Baltic, and the Black Seas are increasingly becoming a risk vector due to the instability of North African and Middle East countries, as well as Russian assertiveness. This is good news for the arms industry as aircraft and ships are some of the most lucrative exports given the high level of technological sophistication that goes into developing them (Chart 11). A war fought in the trenches and jungles by soldiers and insurgents is unlikely to be very profitable, other than for small arms manufacturers. But tensions between sovereign nations across large distances and bodies of water will be highly lucrative for major defense manufacturers that specialize in anti-access/area-denial systems.2 Chart 11Aircraft And Ships Are Most Lucrative Furthermore, capital depreciation is advanced for the most sophisticated (and thus expensive) military technology that was introduced at the tail-end of the Cold War expansionary phase. The U.S. aircraft carrier fleet, for example, is mostly made up of Nimitz-class carriers, which have served for the past 43 years on average (Chart 12). Chart 12Capital Depreciation Is Advanced Our back-of-the-envelope calculations show that the cyclicality in U.S. aircraft carriers is apparent across the major defense systems. Looking at 40 countries and their respective aircraft and MBTs, the bulk of these weapons is beyond the average age of the previous generation when it was retired (Chart 13). Part of the reason for the extended life cycle is better technology, but we suspect the main reason is that these major weapon systems were developed at the height of the Cold War and have not been updated since then. Chart 13Weapons Are Beyond Retirement Age, Need Updating Population Aging The demographic trends of population aging and low birth rates have wide-ranging macroeconomic implications. But they will also impact the defense industry by encouraging automation. There are benefits to automation in the military sphere beyond simply replacing a shrinking pool of able-bodied youth. First, the likely geopolitical hotspots of this century - East Asian seas, the Persian Gulf, the Black Sea, the Mediterranean, and the Indian Ocean - are conducive to high-tech warfare. These bodies of water will be patrolled by drones and plied by autonomous surface vessels while hypersonic missiles deny access to the enemy. Second, by shifting the burden of fighting wars from humans to robots, policymakers will face lower constraints to conflict. This development will not only encourage policymakers to develop autonomous weapon systems, but might also increase the frequency with which they are used, destroyed, and thus re-ordered, shortening the hardware life-cycle and thus increasing the sales volume. Bottom Line: Global multipolarity has seen the U.S. geopolitically deleverage from the Middle East, threaten Europe with abandonment, and put pressure on China in East Asia. These are trends that we believe are here to stay irrespective of President Trump's success or failure in the 2020 election. They are all bullish for defense spending and arms trade. In addition, evolving technological demands and global demographic trends will buoy the arms trade. We expect this era of unbalanced multipolarity to be even more lucrative for global defense contractors. The U.S.: Remain Overweight Anastasios Avgeriou, BCA's chief U.S. equity strategist, recommends that investors remain overweight the pure-play BCA defense index and add exposure to it on any meaningful pullbacks while keeping it as a structural overweight within the GICS1 S&P industrials index. In the U.S., defense spending and investment have bottomed and will continue to accelerate. The Congressional Budget Office (CBO) continues to project that defense outlays will jump further next year (middle panel, Chart 14). We expect that this breakneck pace is actually sustainable, mainly because any fiscal compromise with Democrats on discretionary, non-defense spending would require acquiescence on GOP spending priorities, such as defense. Defense outlays will therefore continue to expand into the 2020s. Chart 14Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs and represents a boost to defense equity revenue growth prospects. Defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 15). Chart 15...And A Flurry Of M&A Is A Boon For Defense A closer look at operating metrics corroborates the view that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 16). Chart 16Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20% annually, or twice as fast as overall capex (Chart 17). Defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 18). Chart 17Industry Is Not Standing Still Chart 18Healthy Balance Sheet With High ROE... Valuations are on the expensive side and in overshoot territory (Chart 19). This is clearly a risk to the overall view. However, if our structural thesis pans out, then defense stocks in the U.S. will grow into their pricey valuations as happened in the back half of the 1960s. Chart 19...But Valuations Are Expensive Bottom Line: The secular advance in pure-play defense stocks remains in place. BCA's U.S. Equity Strategy recommends an above-benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLC, NOC, GD, and RTN. Global Stocks: Be Discerning Beyond the U.S., which global defense stocks are appealing? We believe that there are several market and structural factors to consider. We have ranked national defense sectors by market and structural factors in Tables 3 and 4. Further, Appendix B lists all the non-U.S. weapon manufacturers that we examined, as well as market performance by country. Table 3Russian Defense Sector Attractive On Market Factors Table 4European Companies Rank Highly On Structural Factors Momentum - We like stocks from equity markets that have momentum behind them, i.e. whose stock are above their 200-day moving average. Relative valuation - We like defense sectors that are at a discount relative to the U.S. plays. Performance since Trump - For any country that has outperformed the U.S. aerospace and defense sector since the inauguration of President Trump on January 20, the market believes in its competitiveness vis-à-vis the largest exporter. Geographical diversity - We have ranked country defense sectors by how diverse their sources of revenue are. The higher the figure, the more geographically diverse the revenue pool. Russian and Indian defense plays score very low on this variable as they depend solely on one source: themselves. Exposure to arms trade - We have ranked country defense sectors by how exposed their contractors are to defense as opposed to civilian production. Most companies have major civilian outlays. To fully capture our multipolarity theme, we have ranked companies based on how fully focused they are on producing and selling weapons. Share of global arms market - We recommend that clients buy defense companies in countries that already have a high share of the global arms market. Decisions on purchasing weapons often involve path dependency due to the need to acquire compatible systems. Defense spending - We penalize countries that are already spending 2% of GDP on defense. Their companies will see little boost to domestic demand. It is the other, under-spending countries that will significantly increase their outlays over the next decade. Russian companies score high on market factors. They have good momentum, are attractively valued relative to the U.S. aerospace and defense sector, and are structurally supported. Israel, Canada, Australia, and Brazil are also attractive. All of these are made up of only one stock. On structural factors alone, we like German, British, Italian, and Swedish defense companies. They are geographically diversified, have a respectable share of the global arms trade, and have both reason and room to increase domestic spending. French companies are also structurally attractive, although France may have less need to increase defense outlays. Putting it all together, we are creating a BCA Global Defense Basket. We would include the following global tickers in that basket: A:ASBX, F:AIRS, F:CSF, F:SGM, F:AM@F, C:CAE, D:RHM, D:TKA, I:LDO, I:FCTI, ULE, COB and W:SAAB. Clients may want to include in the basket the five U.S. tickers recommended by BCA's U.S. Equity Strategy: LMT, LLL, NOC, GD, and RTN. We recommend that investors buy this basket, in absolute terms, as a structural investment. Housekeeping We are closing two of our hedges today. First, we are closing long Brent / Short S&P 500 for a gain of 6% and our long U.S. energy / short U.S. information technology for a loss of 1.63%. We initiated the two tactical trades on October 3, which means we timed the market correction perfectly. However, concerns over a supply glut in the oil market meant that the "long" part of our trade did not work out. Furthermore, there have been leaks from the White House to the media that the U.S. may award exceptions to the oil embargo to several critical importers. This would suggest that the Trump administration is beginning to see the risks of its aggressive maximum pressure strategy toward Iran and therefore may be trying to backtrack from it. We still think that the odds of an oil spike due to geopolitics in 2019 are high, but they do appear to be declining, at least for the time being. As such, we are closing the two trades for a net gain. We will continue to monitor the Iran embargo carefully as we expect that geopolitical risks will again be understated in the future, offering investors another opportunity to be long energy. Jesse Anak Kuri, Consulting Editor jesse.anakkuri@mail.mcgill.ca 1 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: W.W. Norton & Company, 2001). 2 Anti-access/area-denial (A2/AD) is a strategy of preventing an adversary from occupying or transiting a geographic area. Defense systems that perform A2/AD functions in the modern era tend to be expensive and technologically sophisticated. They include anti-ship missiles, sophisticated radars, attack submarines, and air-superiority fighter jets. Appendix A Notable Clashes In The South China Sea (2010-18) Notable Clashes In The South China Sea (2010-18) (Continued) Notable Clashes In The South China Sea (2010-18) (Continued) Appendix B Appendix B Chart 20British Defense Stocks Appendix B Chart 21French Defense Stocks Appendix B Chart 22German Defense Stocks Appendix B Chart 23Italian Defense Stocks Appendix B Chart 24Swedish Defense Stocks Appendix B Chart 25Norwegian Defense Stocks Appendix B Chart 26Canadian Defense Stocks Appendix B Chart 27Australian Defense Stocks Appendix B Chart 28Korean Defense Stocks Appendix B Chart 29Japanese Defense Stocks Appendix B Chart 30Singaporean Defense Stocks Appendix B Chart 31Israeli Defense Stocks Appendix B Chart 32Russian Defense Stocks Appendix B Chart 33Brazilian Defense Stocks Appendix B Chart 34Indian Defense Stocks Appendix B Chart 35Turkish Defense Stocks Appendix B Table 1Key Aerospace And Defense Companies Appendix B Table 1Key Aerospace And Defense Companies, Continued

Special Report

Highlights So What? Chancellor Angela Merkel's decision to step down as party chairperson is positive for European political evolution and thus not a risk to the market. Why? The Christian Democratic Union (CDU) is unlikely to turn Euroskeptic, the median German voter is not. Europhile Green Party is surging, throwing shade at the narrative that Germans are souring on Europe. New elections are unlikely in the next 12 months, neither main centrist party would benefit. Chancellor Merkel's stabilizing role in the Euro Area crisis is overstated. Infusion of new blood is precisely what Germany, and Europe, needs. Also... 2019 will be a big year for Europe with multiple decisions to be taken on governance reforms. New leadership in Berlin is exactly what the doctor ordered. Feature German Chancellor Angela Merkel's Christian Democratic Union (CDU) suffered a deep loss in the Hesse election on October 28. Germany's main centrist parties - the center-right CDU and center-left Social Democratic Party (SPD) - suffered deep losses in Hesse, mirroring the results in Bavaria from October 14 (Chart 1). The results have prompted Angela Merkel to confirm that she will not stand for re-election as chair of the CDU at the Hamburg party convention and that she will not seek any political posts after her current term as chancellor ends in 2021. Chart 1Winners And Losers In Bavaria And Hesse In this Client Note, we examine what Chancellor Merkel's decision means for Germany and Europe. Are Euroskeptics Taking Over Germany? The most important question for global investors is whether Merkel's fall from grace is related to a growing trend of populism in Europe. In part, yes. However, Merkel's problem is deeper. Merkel-fatigue in Germany has deeper roots than her decision on immigration in 2015. Polling suggests that Merkel recovered from that crisis and reached a 70% approval rating in mid-2017, only to see a precipitous decline since (Chart 2). Chart 2Merkel's Political Capital Is Spent That said, German Euroskeptic sentiment is not on the rise (Chart 3). In fact, Germans support the currency union at one of the highest clips in Europe. Furthermore, Germans continue to "feel" European (Chart 4). Chart 3Germans Are Europhile... Chart 4...And Feel Quite European In the last two Lander elections in Bavaria and Hesse, the right-wing, Euroskeptic party Alternative for Germany (AfD) underperformed its national polling. Its support in opinion polls, at 16%, appears to be limited by the number of Germans who identify as Euroskeptic, similarly around 14%. In fact, it was the Green Party that surprised in both Bavaria and Hesse, gaining 8.9% and 8.7% respectively. Bottom Line: The short answer is no, Germany is not being taken over by Euroskeptics. True, the 2015 migration crisis has given the AfD a tailwind, allowing it to become entrenched in the political system. Yet just as impressive is the rise of the Europhile Green party (Chart 5). Chart 5Grand Coalition Parties Would Be Crazy To Call A New Election OK, But Will The CDU Move To The Right? The previous question was purposely hyperbolic. The more nuanced question is whether the CDU will swing to the right in the face of AfD's rise? The answer depends on the issue. The two key issues are immigration and EU integration. On immigration, it is simply good politics for Germany's center-right party to steal from the AfD platform. The only downside of adopting a right-leaning immigrant policy is that it will make forming coalitions with the surging Green Party more difficult. It was immigration policy that ultimately prevented the so-called Jamaica Coalition - the CDU, the Green Party, and the pro-business and mildly Euroskeptic Free Democratic Party (FDP) - from becoming a fully-fledged ruling coalition in November 2017. This forced Merkel to re-establish the uninspiring Grand Coalition with the SPD.1 On European integration, it is possible that the CDU will adopt more Euroskeptic rhetoric, but such a move could backfire. First, data suggests that Germans continue to support the euro at a high clip. Second, AfD has already captured the "hard Euroskeptic" voters, whereas FDP has captured "soft Euroskeptics." It is unclear if the CDU has any chance of getting any of those voters back by crowding the "Euroskeptic corner." In fact, data from Bavaria and Hesse indicate that the CDU has been losing voters equally to the Green Party and the AfD. From the perspective of the Median Voter Theory, the CDU has a clear path forward. By remaining Europhile and pro-EU, it can ensure that it does not abandon the 83% of Germans who continue to support the currency union. The German median voter clearly does not want to abandon European institutions. But by ditching Merkel's liberal, pro-immigrant policy, the CDU can ensure that it withstands the AfD's attack on its right flank. Bottom Line: Germany's main center-right party has the luxury of picking its battles with the right-wing AfD. We suspect that the CDU will adopt some of the AfD's anti-immigrant rhetoric and policy, but retain its centrism on other issues. Who Will Replace Merkel As The Head Of The CDU? After months of speculation, Chancellor Merkel has confirmed that she will not pursue the CDU chairmanship at the upcoming December 7-8 party conference in Hamburg. Instead, Germany's ruling party will select a new chairperson, one who will be groomed as Merkel's successor for the 2021 election. The process for selecting the CDU chairperson is largely closed and dominated by party elites. The Federal Executive Board of the CDU - which is made up of the chairperson and 39 other members - sits down with the CDU parliamentary faction to approve the candidates, ensuring that a rogue candidate cannot stage a surprise in the delegate vote. It is highly likely that Merkel will be able to hand-pick a successor. Table 1 is our attempt to collate the likeliest candidates to replace Merkel as the head of the CDU. The list includes only one Euroskeptic candidate - former party whip Friedrich Merz who has not sat in the Bundestag since 2009 - and quite a few outright Europhiles. Merkel's preferred candidate is Annegret Kramp-Karrenbauer - often referred to by German media by her acronym AKK - a centrist who is to the left of Merkel on economic policy, EU matters, and social issues. Table 1Potential Merkel Successors Given the short period of time between now and the Hamburg conference, it is highly unlikely that a surprise candidate - such as the Euroskeptic Merz - will emerge victorious. Merkel, for instance, spent months grooming the party rank-and-file prior to her nomination. Bottom Line: Merkel's successor is likely to be hand-picked. Will Merkel Survive Until 2021? Merkel's chances of staying in power until the end of the current government's term will increase if her favored successor - Kramp-Karrenbauer - emerges victorious in December. A win for an outsider, or someone highly critical of Merkel (such as Jens Spahn, who has disagreed with Merkel on immigration), might hasten Merkel's demise. How would such an outcome play out? If Merkel resigns, the Bundestag would have to elect a new chancellor with a simple majority. Given that the CDU currently governs in a coalition with the SPD, the latter party would have to support the election of a new chancellor. Kramp-Karrenbauer would be acceptable to the SPD, but one of the more contentious candidates may not. A new election would require the chancellor - Merkel or her successor - to lose a confidence vote that he or she has called. However, this is a controversial matter constitutionally as the government must claim that it has reached a legislative impasse on a particular issue. (Chancellor Gerhard Schroder argued in 2005 that his economic agenda was stalled.) The other question is why would either of the ruling parties want new elections at this point? Both centrist parties are tanking in the polls, as both Bavarian and Hesse elections signal and as overall polling indicates (see Chart 5). As such, we suspect that a new election will not take place over the next 12 months, at the very least. Bottom Line: Early elections are not easy to arrange and neither of the two ruling parties want one at the moment. Merkel has at least one more year in power. Investment Implications: Does Any Of This Matter? Chancellor Merkel has lost all of her political capital: that much is clear. As such, her decision to begin the process of finding a successor is a positive development, one that political leaders rarely take willingly. Given the election of a Europhile Emanuel Macron in France in 2017, Berlin needs to find a comparable partner that can carry on reforms. Otherwise, Germany risks wasting the window of opportunity afforded by the Macron presidency to make critical changes to Euro Area governance. On the agenda over the next year or two are several important issues. First, the European Stability Mechanism (ESM) is supposed to be granted new powers, evolving it into a kind of European replacement for the IMF. Some argue - including the ESM's leadership - that this expanded role will necessitate a greater injection of capital, for which obviously Berlin must be on board. Second, the stalled Banking Union project requires Berlin's intimate involvement. A deposit insurance union would go a long way toward stabilizing the Euro Area amid future financial crises. Under Merkel, Berlin has been reticent to greenlight such developments. Third, Berlin must agree with EU peers on several important positions after the European Parliament elections in May 2019. These will include staffing the European Commission. According to press reports this summer, Merkel was focused on ensuring that the next president of the European Commission would be a German. To get her way, Chancellor Merkel supposedly indicated that she would not fight to get a German to replace Mario Draghi, whose term at the ECB is set to expire in October 2019. A change at the top in Berlin, particularly if a Euroskeptic takes over the CDU, may signal a reversal of this strategy. That said, what Berlin wants is not necessarily what Berlin will get, no matter who is in charge. Finally, there is the philosophical question of whether Merkel has been a factor of stability for Europe over the past decade. We believe the answer is no. Not for any normative reason but rather because she has been an intently domestic chancellor. Investors have been overstating Merkel's role as the "anchor" of Euro Area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent Euro Area fiscal backstop mechanism due to the upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Such delays and hesitations have cost Europe considerable momentum throughout the crisis and since. As such, we believe that Chancellor Merkel's decision presents considerable upside for European politics and limited downside. Infusion of new blood in Berlin is the only way for Europe to restart the stalled governance reforms. However, much will depend on whether the CDU takes a significant turn towards a "softer Euroskeptic" position or maintains its traditional pro-European outlook. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The name references the colors of the three parties (black for CDU, green for the Green Party, and yellow for the FDP).

Neutral We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. As shown in the chart at the side, technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. In Monday's Weekly Report, we highlight four key reasons why it is time for us to downgrade. First, this capital intensive industry has been reducing capex but increasing their debt load to retire equity, which erodes a cushion should cash flow growth suffer a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Third, two of our key rail industry Indicators have suddenly turned south, particularly our Rail Shipment Diffusion Indicator which has fallen off a cliff recently. Lastly, industry operating metrics are deteriorating, at the margin, and intermodal rail shipments have rolled over. Bottom Line: We locked in relative gains of 15% since inception in the S&P rails index and downgraded to neutral on Monday; please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.

Highlights Growth Scare: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Feature Just like that other great October tradition, Halloween, market volatility has returned to spook investors. Both the MSCI All-Country World Index and S&P 500 index are officially in correction territory, down -10% from the highs reached in September. The causes for the pullback range from high-profile third quarter U.S. earnings disappointments to increased evidence that the U.S.-China tariff war is negatively impacting U.S. investment spending. Yet the reaction from global bond markets has been relatively muted for such a large pullback in stocks. Benchmark 10-year government bond yields for the major developed markets are down from their peaks, but the declines have been smaller in countries where central banks are in a rate hiking cycle (U.S. -14bps, Canada -19bps) relative to countries where central banks are on hold (Germany -20bps, U.K. -31bps). One possible reason for this discrepancy is that the downtrend in data surprises appears to have stabilized in the U.S. and, even more importantly, China, while European data continues to disappoint relative to expectations (Chart of the Week). Chart of the WeekNoisy Equities, Calm Bonds We still do not believe that global bond yields have peaked for the cycle. We continue to recommend a below-benchmark strategic bias on overall duration exposure, but with only a neutral allocation to global corporate bonds that favors U.S. credit. On a more shorter-term tactical basis, there is a risk that yields could decline further, with more credit spread widening than seen during the current risk-off episode, if economic data starts to disappoint in the U.S. where growth has so far been resilient. Staying up in credit quality within an allocation to U.S. corporates is one way to hedge against such an outcome. Bond Yields Are Normalizing, Bond Volatility Is Not The selloff in risk assets has resulted in a pickup in widely-followed market volatility measures like the U.S. VIX index. Yet when looking at the level of realized total return volatility across all major asset classes, the current bout of turbulence has been unimpressive outside of global equities. In Chart 2, we present an update of a chart from our 2018 global bond outlook report, showing the current levels of realized volatility across different asset class benchmarks compared to their historical ranges. The vertical lines in each chart represent the range between 1999 and 2017 of annualized monthly volatilities for global government bonds, credit, equities, currencies and commodities. The red triangles represent the most recent 13-week annualized volatilities for those same asset classes. What stands out in the chart is that volatilities are off the historical lows for global equities, Italian government bonds and industrial commodities, yet volatilities remain subdued for developed market government bonds, global corporate debt and currencies. Chart 2Bond Volatility Remains Subdued, Despite More Volatile Equities We have long argued that the shift to a structurally higher level of volatility across all asset classes will show up first with a rise in bond volatility. In the U.S., in particular, sustained periods of elevated volatility for both Treasuries (as measured by the MOVE index) and stocks (as measured by the VIX index) have occurred alongside episodes of greater variance in nominal GDP growth (Chart 3). When the latter rises, that also triggers more uncertainty about the future path of monetary policy which feeds into a rise in expected bond volatility. That, in turn, impacts volatility in growth sensitive assets like equities, credit and commodities. Chart 3Equity Vol Responding To Growth Uncertainty Right now, nominal GDP volatility has picked up in the U.S. but still remains low by historical standards (middle panel). Some of that increased growth volatility can be attributed to the Trump fiscal stimulus coming at a time of full employment, which has helped boost both real GDP growth and U.S. inflation. Interest rate markets have moved to discount more Fed hikes in response, but the Fed's steady pace of well-telegraphed, 25bps-per-quarter rate increases is likely acting to dampen Treasury market volatility. As we have written about extensively throughout the course of 2018, the hurdle for central banks (not just the Fed) to shift to a less hawkish or more dovish policy stance is much higher when unemployment is low and inflation is closer to central bank targets. In such an environment, the correlation between equity and bond returns should be weaker than during periods of excess capacity and low inflation when central banks can stay dovish. That can be seen in Chart 4, which plots the trailing 52-week correlation of total returns for equities and government bonds for the major developed markets (top panel), along with the 10-year market-based inflation expectations for each country (bottom panel). For almost all countries shown, the stock/bond correlation has risen to zero away from the negative correlations that dominated the post-crisis years. That move in correlations has occurred alongside a more stable backdrop for inflation expectations, which are much closer to central bank targets. The lone exception is, of course, Japan, where inflation remains disappointingly low and the Bank of Japan continues to keep a tight lid on interest rates. Chart 4More Stable Inflation Means Less Correlated Stock & Bond Returns Besides more stable inflation, another factor preventing yields from falling as much as implied by the declines in equity markets is that global bond yields remain overvalued relative to trend economic growth. One way to assess this is to look at the level of real bond yields relative to a moving average of actual GDP growth. We show this for the major developed economies in Charts 5 & 6, which plot rolling 3-year moving averages of real GDP growth (a proxy for "trend" or potential growth) versus real 5-year government bond yields, 5-years forward. For the latter, we take the nominal 5-year/5-year forward yield and subtract a five-year moving average of realized headline inflation for each country, rather than market-based inflation-linked instruments like CPI swaps or TIPS, to allow for a longer history of real yields in the charts. Chart 5Real Bond Yields Are Still Too Low ... Chart 6... Compared To Real Economic Growth For all countries show, real bond yields remain below the level of real growth. The gap between the two is smallest in the U.S. and Canada - unsurprising, as central bankers have been tightening monetary policy, and helping push up real interest rates, in both countries. Bonds look most overvalued in core Europe, Japan and Sweden where policymakers have been using negative interest rates and quantitative easing (QE) to hold down bond yields. Real yields in those countries are between 200-300bps below our proxy for trend real growth. With such a large gap between actual growth and interest rates, it becomes harder for policymakers to consider easing monetary policy, or at least slow the pace of policy normalization, in response to more volatile financial markets. It should not be a surprise that last week, during a period of global market turmoil, the European Central Bank and Sweden's Riksbank both signaled that they remain on pace to end QE and begin hiking interest rates within the next 6-12 months, while the Bank of Canada delivered another 25bp rate hike. In the absence of a VERY large global growth shock, global real yields should be expected to increase over at least the next year, and a defensive posture on global duration exposure should be maintained. One such shock could come from a deeper downturn in China than has already occurred in 2018, which would feed into a bigger slowdown in non-U.S. growth. Another shock could come from the U.S. if the recent pullback in core durable goods orders (Chart 7) is a sign that a) U.S. companies are becoming more worried about the impact of U.S.-China trade tariffs on global growth; and/or b) the impact of the Trump fiscal stimulus is already starting to fade. Such a move could be exacerbated by a larger downturn in housing activity than seen already in response to rising mortgage rates. Chart 7Treasuries Are Exposed To A U.S. Growth Scare These shocks, if large enough, could trigger a short-covering rally in U.S. Treasuries, where sentiment remains very depressed (bottom panel). However, with leading economic indicators still pointing to above trend U.S. growth, and with U.S. consumer spending holding firm alongside a tight labor market and faster wage growth, such a pullback in yields would likely be short-lived and difficult for investors to time successfully. Bottom Line: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada Update: The BoC Stays Hawkish The Bank of Canada (BoC) delivered another rate hike last week, lifting the policy rate by 25bps to 1.75%. The language used to explain the hike was surprisingly hawkish. In the press conference following the BoC meeting, Senior Deputy Governor Carolyn Wilkins noted that the policy rate remains negative in real terms and is still below the central bank's estimate of neutral (between 2.5% and 3.5%). She also noted that the term "gradual" was no longer used to describe the pace of monetary tightening, so as not to give the impression that policy was following a steady predetermined path similar to the Fed's tightening cycle - potentially, a sign that more hawkish surprises could be in the offing. The BoC also sounded more optimistic on the outlook for the Canadian economy, while sounding less concerned about the two factors that should cause the most worry - high consumer debt levels and uncertainty over global trade. The more upbeat tone is at odds with the current pace of economic growth in Canada, which has slowed. GDP growth has decelerated to 1.9% from 3.0% at the end of 2017, while the OECD's leading economic indicator for Canada is also in a downtrend (Chart 8). In the Monetary Policy Report (MPR) that was also released last week, the latest BoC forecasts for Canadian real GDP growth for 2019 and 2020 were essentially left unchanged. Chart 8Is The BoC's Growth Optimism Justified? The BoC noted that the composition of demand within the Canadian economy was shifting away from consumption and housing towards business investment and exports. That can be seen in the most recent data that shows sluggish consumer spending (middle panel) and rebounding export growth (bottom panel). The central bank attributes the softer path for consumption to its own interest rate increases and changes to housing market policies, both of which have forced households to adjust their spending patterns. That is evident in the sharp decline in house price growth, deceleration of household credit growth and the softening trends in housing starts and residential investment spending (Chart 9) Chart 9Canadian Housing Has Cooled Off The BoC is of the view, however, that consumer spending will rebound (but not overheat) on the back of strong household income growth and a pickup in net immigration inflows that is boosting population growth. The other area of diminished concern for the central bank is investment spending, which has been negatively impacted by the uncertainty over the renegotiation of the North America Free Trade Agreement (NAFTA). That smooth acronym is now gone, to be replaced by the more awkward "USMCA", or United States-Mexico-Canada Agreement. That new trade deal has reduced the immediate uncertainty over the impact of U.S. trade policy on Canada, although the BoC did note in the MPR that there was still the potential for lingering uncertainty based on previous U.S. trade actions (i.e. on steel and aluminum imports to the U.S.) and because the USMCA has not yet been ratified. The BoC did make an upward adjustment to its assumptions regarding the hit to Canadian growth from U.S. trade policy compared to the July MPR. The level of exports is now only expected to fall by -0.3% over the next two years (vs -0.7% in the July MPR) and business investment is expected to decline by -0.7% over the same period (vs -1.4% in the July MPR). The reduction in trade uncertainty should be expected to free up demand for capex in Canada. The Q3/2018 BoC Senior Loan Officers' Survey reported a further easing of lending standards from the Q2 survey (Chart 10). The central bank's Q3 Business Outlook Survey also noted that firms' investment intentions continued to strengthen to the highest level in eight years (middle panel). This was primarily due to increased expectations for future sales growth, coming at a time of high reported capacity pressures (bottom panel). Importantly, the Business Outlook Survey took place before the USMCA deal was reached, suggesting that the data may actually understate sales expectations. This bodes well for future gains to overall GDP growth from business investment spending. Chart 10Canadian Companies Need To Invest & Hire That same Business Outlook Survey also reported that firms are continuing to experience labor shortages, most notably in sectors such as construction, transportation and information technology. This is a sign that employment growth should remain firm in Canada. Coming at a time when the unemployment rate at 5.9% remains well below estimates of full employment, this suggests that there could be some upward pressure on inflation. Canadian headline CPI inflation currently sits at 2.2%, while core CPI inflation is at 1.8% (Chart 11). That is a sharp decline from the 3% inflation seen in July, which was the result of an unexpected surge in airline fares. Yet at current levels, Canadian inflation sits right at the midpoint of the BoC's 1-3% target range. Furthermore, the BoC's own assessment is that the output gap is in a range of -0.5% to +0.5%, in line with the estimates from the IMF and OECD (middle panel). Although headline wage growth has cooled in recent months, the BoC's preferred measure that incorporates several wage measures ("Wage-Common"), has been stable near the same 2% levels as seen for CPI inflation. Chart 11Canadian Inflation At BoC Target Expect More BoC Hikes With the Canadian economy operating at full employment and with inflation at target, the BoC seems determined to push the policy rate back up towards their estimated 2.5%-3.5% range for the neutral rate. This means another 75-175bps of additional rate increases. At the moment, there are only 49bps of hikes over the next year discounted in the Canadian Overnight Index Swap (OIS) curve (Chart 12). This leaves Canadian bond yields exposed to additional rate increases. This is especially true given our forecast of continued Fed interest rate increases in 2019, as the BoC has been playing a game of "Follow the Leader" with the Fed during the current tightening cycle (top panel). Chart 12Stay Underweight Canadian Government Bonds In terms of our recommended fixed income investment strategy, we continue to favor: an underweight stance on Canadian government bonds for global bond investors a below-benchmark duration stance within dedicated Canadian bond portfolios long positions in Canadian inflation protection (CPI swaps or inflation-linked bonds) While we expect the Canadian yield curve to flatten as the BoC delivers more rate hikes than currently discounted over the next year, we do not see the 2-year/10-year curve flattening by more than is currently priced in the forwards. This is not the case for an outright duration bet, where the forwards are currently priced for very little upward movement in Canadian bond yields over the next year. Therefore, we prefer to stick with directional bets on Canadian yields (higher) and Canadian relative bond performance versus global peers (worse). Bottom Line: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns