Economy

Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth   Chart 6China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6).  Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth     Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth.   Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating       Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand.   Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15).     Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives       We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves   Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector   U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018).   Strategy & Market Trends MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades

Highlights Our leading gauges of EM commodity-demand growth indicate global industrial-commodity demand has troughed and will be moving higher in the wake of supportive global financial conditions. The magnitude and speed of any commodity-demand rebound hinges on the joint evolution of the USD, which remains close to record highs, and global economic policy uncertainty. Reduced policy uncertainty will translate to a weaker USD, which, all else equal, will be bullish for commodity demand. Chinese economic stimulus remains weak, suggesting policymakers are holding off deploying aggressive fiscal and monetary policy until later this year or next year. Policy risk remains the chief threat to a robust recovery of industrial-commodity demand globally. A ceasefire in the Sino-US trade war will not resolve deeper trade and security issues, which means global financial easing must offset still-pronounced economic uncertainty that is keeping the USD well bid. If policy uncertainty remains high, it will continue to be a headwind for commodity-demand growth.  Feature EM GDP growth is showing signs of accelerating, based on our EM Commodity-Demand Nowcast model. This will translate to higher commodity demand in coming months (Chart of the Week). Our EM Commodity-Demand Nowcast is a coincident indicator of commodity demand, comprised of our Global Industrial Activity (GIA) Index, and our Global Commodity Factor (GCF) and EM Import Volume (EMIV) models (Chart 2). The GIA index uses trade data, FX rates, manufacturing data, and Chinese industrial activity statistics to gauge current global industrial activity, which is highly correlated with trade-related activity. The GCF uses principal component analysis to distill the primary driver of 28 different commodity prices traded globally. Lastly, the EMIV model is driven by EM import volumes reported with a two-month lag by the CPB in the Netherlands, which we update to current time using FX rates for trade-sensitive currencies, commodity prices and interest rates variables. Chart of the WeekEM Commodity-Demand Nowcast Hooking Up Chart 2BCA EM Commodity-Demand Nowcast Components Show Growth Resuming Globally We expect the recovery in global economic growth to reduce the marginal impact of the global policy uncertainty on the USD, and on oil demand. Our EM Commodity-Demand Nowcast is strongly correlated with y/y growth in nominal EM GDP and non-OECD oil consumption. Its improvement supports our view oil demand will continue to strengthen, particularly next year, when we expect growth to average 1.4mm b/d. We expect the recovery in global economic growth to reduce the marginal impact of the global policy uncertainty on the USD, and on oil demand.1 As demand strengthens – and recession fears subside – economic policy uncertainty’s contribution to safe-haven demand for the USD will diminish. This means economic growth will once again be the main driver of cyclical commodity demand growth. The GIA component of our Nowcast is sensitive to real activity in China, which is the largest consumer of base metals, iron ore and steel. Here, it is instructive to see the components other than manufacturing appear to have bottomed, which, at the margin, should be supportive of base metals, iron ore and steel products (Chart 3). The China Economy Component of the index has hooked higher last month, but it still is lagging. This suggests policymakers are holding off on deploying fiscal and monetary stimulus aggressively for now. We expect this will change by 1H20, if organic growth fails to materialize.2 Chart 3BCA GIA Index Components Point Toward Demand Growth Global Financial Conditions Support Commodity Demand For the better part of this year, systemically important central banks globally have been running accommodative monetary policies. With this week’s rate cut, the Fed now has lowered rates three times this year, and the ECB is preparing to roll out QE once again. We expect monetary policy to continue to support a revival of industrial-commodity demand (Chart 4). The easing of global financial conditions has been a pillar of our view. The easing of global financial conditions has been a pillar of our view that globally accommodative monetary policy will reverse the damage done to global commodity demand growth by the Fed’s rates-normalization policy last year and China’s deleveraging campaign of 2017-18. Financial markets have responded to this stimulus, as our colleague Rob Robis points out in this week’s Global Fixed Income Strategy.3 Global equity markets have moved 10% higher y/y, as financial conditions ease (Chart 5): Chart 4Global Financial Conditions Remain Supportive For Commodities Chart 5Global Equities, LEIs Move Higher “Equity prices are an excellent leading indicator of global growth, while bond yields typically reflect current economic conditions. … We see no reason to discount the positive message on growth from rallying equity markets, especially when confirmed by an improvement in our global leading economic indicator (LEI), led by the more cyclical emerging market (EM) countries.” (Chart 6). The real economy also is responding to stimulative global financial conditions, as EM manufacturing activity indicates. EM manufacturing is outpacing activity in DM markets (Chart 7). This is bullish for trade volumes and EM income growth, which will, all else equal, be supportive of industrial-commodity demand (Chart 8). Chart 6EM Equity, FX Markets Strengthen Chart 7EM Manufacturing Outperforms DM Chart 8EM Manufacturing Correlates With Trade Growth Economic Policy Uncertainty Continues To Dog Growth As promising as these indications of a revival in commodity demand may be, global economic policy uncertainty – particularly as regards the Sino-US trade war and trade in general – will remain a hindrance to reviving commodity demand. We have shown that global economic uncertainty stifles oil-demand growth, and commodity demand generally.4These policy risks are exogenous to the commodity markets and are, therefore, very difficult to hedge. While we expect economic uncertainty globally to decline, it will not completely evaporate. It will remain elevated vs. its historical average, despite the decline from its recent record-high level. Presently, commodity markets are positively discounting the likely “phase one” trade deal expected to be agreed between Presidents Trump and Xi Jinping. We expect this to reduce economic uncertainty and weaken the USD, at the margin. In addition, as our colleague Matt Gertken notes in last week’s Geopolitical Strategy, other sources of uncertainty – particularly a disorderly Brexit – also are being addressed: “Not only are U.S.-China relations slightly thawing, but also the risk of the U.K. leaving the EU without a withdrawal agreement has collapsed. This will reinforce Europe’s underlying political stability despite the manufacturing recession and help create a drop in global uncertainty.”5 Still, while we expect economic uncertainty globally to decline, it will not completely evaporate. It will remain elevated vs. its historical average, despite the decline from its recent record-high level. Consequently, monetary policy will have to remain accommodative in order for the momentum in global growth – mainly in EM economies – to increase and reach the threshold where fears of recession dissipate, a necessary condition required to reduce the correlation between global economic policy uncertainty and the USD. For the USD to no longer be a headwind to commodity-demand growth, monetary policy globally will be forced to offset the remaining, lingering economic policy uncertainty that is keeping the USD well bid.  There still are significant risks going into 2020, as our geopolitical strategists note: “Uncertainty will remain elevated beyond the fourth quarter, however, for two main reasons. First, US uncertainty will rise, not fall, as a result of the impending 2020 election. Second, the trade ceasefire is highly unlikely to resolve the slate of disagreements and underlying strategic distrust plaguing U.S.-China relations. This will cap the rebound we expect in global business sentiment.” So, while uncertainty will fall as President Trump retreats from his previously intransigent trade position vis-à-vis China, its diminution will be limited. All the same, the chances markets will return to the status quo ante are close to zero. This means that for the USD to no longer be a headwind to commodity-demand growth, monetary policy globally will be forced to offset the remaining, lingering economic policy uncertainty that is keeping the USD well bid. So far, it would appear this is happening, given the improvement in global financial conditions currently visible in the data. However, it is not a given this will continue, and markets will be forced to keep a weather eye on these conditions going forward. Bottom Line: Global financial conditions are easing significantly and propelling financial markets higher, particularly global equity markets. We expect the real economy – i.e., commodity markets – also will benefit from monetary accommodation and that aggregate demand will lift as EM income growth improves. This likely will put downward pressure on the USD. Importantly, if the divergence between EM and DM increases, it could offset the impact of global economic policy uncertainty’s impact on the USD and reduce the demand for dollars. We continue to expect oil demand to be supported by monetary accommodation globally and fiscal stimulus as 2019 winds down and into 2020. We also expect real interest rates will remain soft, as central banks try to keep financial conditions loose enough to encourage risk taking and investment. This will continue to support demand for industrial commodities, particularly oil and base metals.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up NB: This week we are adopting a new format and moving our short summaries of other commodity markets to the back of our Weekly Report, which will align our layout with BCA Research’s new look. Energy: Overweight. Saudi Aramco is set to IPO November 3, 2019, according to Reuters. The company is looking at a float of 1 – 2% on the Tadawal, which could be the largest IPO in history.6 Separately, the Trump administration renewed Chevron’s waiver to operate in Venezuela for three months last week. Chevron produces ~ 47k b/d in Venezuela. Sanctions waivers for Halliburton, Schlumberger, Baker Hughes and Weatherford International also were renewed.7 Base Metals: Neutral. LME nickel closed close to 12% below the five-year high registered September 2, following the announcement of an immediate ban in exports of nickel ore from Indonesia on Monday. Although LME nickel stocks are at an 11-year low refined nickel production is expected to rise 4.5% next year to 2.5mm MT, according to MB Fastmarkets. Precious Metals: Neutral. Gold traded sideways going into this week’s FOMC meeting. We remain long gold as a portfolio hedge, and continue to expect it to move higher as 4Q19 progresses. Ags/Softs: Underweight. Grains remain lackluster, despite President Trump's expectations of cementing his “phase one deal” with Chinese President Xi Jinping, which will open the way for China to purchase some $40-$50 billion worth of US ag products. Footnotes 1 We discuss the impact of global economic policy uncertainty on oil prices at length in Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth, which we published October 17, 2019.  2 Our China Investment Strategy team cautions investors to wait for “hard data” to confirm recent indications the economy has bottomed and will be moving toward stronger growth.  Please see our China Macro And Market Review published October 2, 2019.  It is available at cis.bcaresearch.com. 3 Please see Big Mo(mentum) Is Turning Positive, published by BCA Research’s Global Fixed Income Strategy October 29, 2019.  It is available at gfis.bacresearch.com. 4 Please see Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth, which we published October 17, 2019, for more detail on the transmission mechanism from global economic uncertainty to the USD to commodity demand.  Briefly, as uncertainty increases safe-haven demand for the USD increases.  This stifles demand growth for commodities generally, because it increases the local-currency costs of commodities ex-US. 5 Please see Is China Afraid Of The Big Bad Warren?, a Special Report published by BCA Research’s Geopolitical Strategy October 25, 2019.  It is available at gps.bcaresearch.com. 6 Please see Saudi Aramco aims to begin planned IPO on Nov. 3: sources published by reuters.com on October 29, 2019. 7 Please see US Extends Chevron's Venezuela waiver published by Argus Media’s argusmedia.com service October 21, 2019. Investment Views and Themes Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in Summary Of Trades Closed In 2018 Summary Of Trades Closed In 2017 Summary Of Trades Closed In 2016

Analysis on Mexico and Central Europe is available on pages 6 and 10, respectively. Highlights Deflationary pressures have been intensifying in Malaysia and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. In Mexico, pieces are falling into place for stocks to outperform the EM equity benchmark on a sustainable basis. We are also keeping an overweight allocation on Mexican sovereign credit and local currency bonds. In Central Europe (CE), inflation will continue to rise as both labor shortages and ultra-accommodative monetary and fiscal policies promote strong domestic demand. We are downgrading our allocation of CE local currency bonds from overweight to neutral. Malaysia: Besieged By Deflationary Pressures Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. The Malaysian economy continues to face strong deflationary pressures. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Chart I-1The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Chart I-3Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-5Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Mexico: Raising Our Conviction On Equity Outperformance Mexican local currency bonds, as well as sovereign and corporate credit, have been one of our highest conviction overweights for some time. These positions have played out very well (Chart II-1). Presently, pieces are falling into place for Mexican stocks to outperform the EM equity benchmark on a sustainable basis. First, long-lasting outperformance by Mexican local currency bonds and corporate credit will lead to the stock market’s outperformance relative to the EM benchmark. Chart II-2 shows that when Mexican local currency bond and corporate dollar bond yields fall relative to their EM peers, the Bolsa tends to outperform. In brief, a relative decline in the cost of capital will eventually translate into relative equity outperformance. Chart II-1Mexico Vs. EM: Domestic Bonds And Credit Markets Chart II-2Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Second – as discussed in detail in our previous Special Report – market worries about Mexico’s fiscal position are overblown, especially relative to other developing nations such as Brazil and South Africa. Orthodox fiscal and monetary policies, as well as low public debt, warrant a lower risk premium in Mexico, both in absolute terms and relative to other EM countries. Moreover, market participants and credit agencies have overstated the precariousness of Pemex’s debt and financing requirements. Pemex U.S. dollar bond yields have been falling steadily compared to EM aggregate corporate bond yields since the announcements of policies aimed at supporting the company’s debt sustainability. We have discussed Pemex’s financial sustainability and its effect on public finances in past reports.1  Third, having cut rates twice since September, the Central Bank of Mexico (Banxico) has embarked on a rate cutting cycle. This is positive for stock prices, as it implies higher equity valuations and will eventually put a floor under the economy.  Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. Banxico members have been vocal about their desire to cut rates further, which is being foreshadowed by the swap market (Chart II-3, top panel). Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. The slowdown in the domestic economy and Andrés Manuel López Obrador’ (AMLO) administration’s tight fiscal policy will enable and encourage Banxico to further ease monetary policy (Chart II-3, bottom panel). Fourth, another positive market catalyst for Mexican equities is the ongoing outperformance of EM consumer staples versus the overall EM index. Consumer staples have a large 35% share of the overall Mexico MSCI stock index, while this sector in the EM MSCI benchmark accounts for only 7%. Therefore, durable outperformance by consumer staples often hints at a relative cyclical outperformance for the Mexican bourse (Chart II-4). Chart II-3Mexico: Continue Betting On Lower Rates Chart II-4Mexican Equities Are A Play On Consumer Staples Chart II-5Mexican Stocks Offer Reasonable Value Finally, Mexican equities are not expensive. Chart II-5 illustrates that according to our cyclically-adjusted P/E ratios, Mexican stocks offer good value in both absolute terms and relative to EM overall. We continue to believe AMLO’s administration is proving to be a pragmatic government with the aim of reducing rent-seeking activities and addressing structural issues such as poverty, corruption and crime. These policies will be positive for the economy over the long run and share prices will move higher in anticipation. Bottom Line: We are reiterating our overweight allocation on Mexican sovereign credit and domestic local currency bonds within their respective EM benchmarks. With further rate cuts on the horizon, yet upside risks to EM local currency bond yields, we continue to recommend a curve steepening trade in Mexico: receiving 2-year and paying 10-year swap rates.  We now have high conviction that Mexican share prices will stage a cyclical outperformance relative to their EM peers. The bottom panel of Chart II-4 on page 8 illustrates that Mexican stocks seem to have formed a major bottom and are about to begin outperforming the EM equity benchmark. Dedicated EM equity managers should have a large overweight allocation to Mexican stocks. Our recommendation of favoring small-caps over large-cap companies in Mexico has been very profitable since we argued for this trade last November. We are taking a 12.9% profit on this position and recommend keeping an overweight allocation to both Mexican large- and small-caps within an EM equity portfolio.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Central Europe: An Inflationary Enclave In Deflationary Europe Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. CE economies have stood out as an inflationary enclave in Europe. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Chart III-3Favor CZK Versus PLN & HUF Chart III-4Germany's Manufacturing Cycles And CE Inflation Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Chart III-5Strong Domestic Demand In CE… Chart III-6...Entails Divergences In Manufacturing With Euro Area Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Chart III-7Genuine Inflationary Pressures In Central Europe Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating Investment Implications Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Anddrija Vesic Research Analyst andrija@bcaresearch.com     Footnotes 1. Please see Emerging Markets Strategy, "Mexico: The Best Value In EM Fixed Income," dated April 23, 2019 and "Mexico: Crying Out For Policy Easing," dated September 5, 2019, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Bank Credit Analyst

Highlights The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. Feature There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.1 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”2 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”3 Chart II-1Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.4 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart II-1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart II-2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart II-2China’s Mean Reverting Narrative In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart II-3). Chart II-3The Beijing Consensus Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead To Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. Diagram II-1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram II-1Trade War In A Bipolar World However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.5 The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.6 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart II-4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart II-4The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart II-5). This is for three reasons: Chart II-5Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.7 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. Diagram II-2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram II-2Trade War In A Multipolar World Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.8 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts II-1 and II-4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”9 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”10 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”11 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.12 Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.13 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart II-6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart II-7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart II-6The Allies Traded With Germany ... Chart II-7… Right Up To WWI   Chart II-8Japan And U.S. Never Downshifted Trade A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart II-8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram II-2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart II-9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart II-9The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart II-10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart II-11). Chart II-10Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Footnotes 1   Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 2   Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 3   See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).  4  The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 5   Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 6   We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own.  7   See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 8   Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 9   See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 10   Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 11   Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 12  Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia.  13  See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.

Bank Credit Analyst

Highlights Declining uncertainty over policy, stabilizing growth in China and improvements in international liquidity, all will allow global economic activity to pick up in the months ahead. A weak dollar will reinforce this positive economic outlook; investors should favor pro-cyclical currencies such as the AUD, NZD and SEK. Bond yields will rise and stocks will outperform bonds on a 12- to 18-month basis. Cyclical stocks are more attractive than defensives. European stocks will outperform U.S. equities and European financials will shine. Copper is a promising buy; stay long the silver-to-gold ratio. Feature The outlook for risk assets and bond yields hinges on global economic activity. The S&P 500 has hit a new high, but our BCA Equity Scorecard Indicator remains non-committal towards stocks (Chart I-1). If global economic activity improves, the Scorecard will begin to flash a clear buy signal, but if growth deteriorates, the indicator will point towards sell. Chart I-1Stocks Could Go Either Way Cautious optimism is in order. Politics, China, liquidity conditions and the dollar collectively will determine the global economic outlook. The liquidity backdrop has significantly improved, political uncertainty should recede and China will morph from a headwind to a modest tailwind. A weak dollar will indicate that the world is healing, and also will ease global financial conditions which will facilitate economic strength. We remain committed to a positive stance on equities on a 12- to 18-month horizon, and recommend below-benchmark duration in fixed-income portfolios. Cyclicals should outperform defensives, European banks offer an attractive tactical buying opportunity and European equities will outperform their U.S. counterparts. Heightened Risks… Chart I-2Risks To The Economy And Stocks Many domestic indicators overstate the intrinsic fragility in the U.S. The Duncan LEI, which is the ratio of consumer durable spending and residential and business investment to final sales, has flattened. Therefore, the S&P 500 looks vulnerable and real GDP may contract (Chart I-2). CEO confidence and small business capex intentions warn of a looming retrenchment in household income (Chart I-2, bottom two panels). If consumer spending weakens, then a recession will be unavoidable. As worrisome as these indicators may be, we previously discussed that the major debt imbalances that often precede U.S. recessions are absent,1 the rebound in housing starts and homebuilding confidence is inconsistent with a restrictive monetary stance,2 and pipeline inflationary pressures are absent.3 Instead, business confidence and the Duncan LEI have been eroded by heightened political uncertainty and weak global manufacturing and trade. … Meet Receding Policy Uncertainty … The two biggest sources of policy uncertainty affecting markets, the Sino-U.S. trade war and Brexit, are diminishing. However, the U.S. election will continue to lurk in the background. Chart I-3Weaker Brexit Support = No Hard Brexit Support Brexit Westminster and Britain’s Supreme Court have rebuked U.K. Prime Minister Boris Johnson’s threat of a “No-Deal” Brexit. Moreover, parliamentary support for his latest plan, which essentially keeps Northern Ireland’s economy within the EU, indicates that the probability of a “No-Deal” Brexit has collapsed to less than 5%. This assessment is reinforced by the delay of Brexit to January 31, 2020. An election is scheduled for December 12 and the chance of a new referendum to vet the deal is escalating. According to Matt Gertken, BCA’s Geopolitical Strategist, an election does not increase the risk of a hard Brexit. Meanwhile, support for Brexit is near its lowest point since the June 2016 referendum (Chart I-3). Thus, a new plebiscite would not favor a “No Deal” Brexit. Sino-U.S. Trade War Chart I-4Why The Trade-War Ceasefire? The trade war truce will also greatly diminish economic uncertainty. Uncertainty created by the China-U.S. conflict accentuated the collapse in business confidence and capex intentions. The “phase one deal” announced earlier this month will likely materialize. The White House’s tactical retreat on trade is tied to U.S. President Donald Trump’s desire for a second term. He cannot risk inflicting further economic pain on his base of constituents.  Weekly earnings are decreasing for workers in swing states located in the industrial rust belt, especially in those areas that Trump carried in 2016 (Chart I-4). Those swing states are most affected by the slowdown in the global manufacturing and trade sectors. Beijing is also motivated to agree to truce due to its soft economy and deflationary pressures. An easing in trade uncertainty will be positive for the domestic economy. China’s willingness to replace Carrie Lam, the embattled Chief Executive of Hong Kong, and to withdraw the extradition bill at the heart of the protests confirms its eagerness to come to an agreement with the U.S. China’s readiness to make a deal is also made evident by its increasing imports of U.S. agricultural products (Chart I-4, bottom panel). Ultimately, the U.S. will not implement tariffs in December on $160 billion of Chinese shipments. Consequently, investors and businesses should become less concerned about the chances of a worsening trade war. Moreover, chances are growing of a decrease (but not a complete annulation) of the previously imposed U.S. tariffs on China. … And A Q1 2020 Acceleration In Global Growth Global economic activity will improve in Q1 2020 because the drag from China will dissipate and global liquidity conditions will improve. Many activity indicators increasingly reflect these fundamental supports. China China’s economy has reached a new low point: Q3 annual GDP growth is at a 27-year low of 6%, capital spending is weak, industrial production and profits show little life, the labor market is soft, and imports and exports continue to contract. However, a turn in policy has materialized, which will protect the domestic economy. Moreover, this summer’s Politburo and State Council statements showed an increased willingness to reflate the economy. The global economy will accelerate in Q1 2020. Credit creation has stabilized and monetary conditions have eased (Chart I-5). Faced with producer price inflation of -1.2% and employment PMIs of 47.3 and 48.2 in the manufacturing and non-manufacturing sectors, respectively, authorities have allowed the credit impulse to improve to 26% of GDP from a low of 23.8%. In accordance with this new policy direction, the drag from the shadow banking system’s contraction will slow considerably, thanks to a stabilization in both the growth rate of deposits of non-depository financial institutions and the issuance of bonds by small financial institutions. Additionally, the emission of local government bonds will accelerate. Beijing has also meaningfully eased fiscal policy, which is its preferred reflationary tool. Policymakers have cut taxes by 2.8% of GDP in the past two years. The marginal propensity of households to consume is trying to bottom (Chart I-5, bottom). If history is a guide, the acceleration in the rate of change of public-sector capex will fuel this turnaround in China’s marginal propensity to consume, and push up BCA’s China Activity Indicator (Chart I-6). Chart I-5Overlooked Chinese Improvements Chart I-6Public Investment Matters   Chart I-7A Bottom In Chinese Exports Growth? China’s economy is unlikely to bounce back as violently as in 2009, 2012 or 2016. Authorities are much more circumspect in their use of credit to reflate the economy than they were previously. Moreover, the regulatory environment will prevent a boom in the shadow banking system. Nonetheless, the fiscal push and the end of the decline in aggregate credit growth will allow the Chinese economy to stabilize and maybe pick up a bit. Therefore, China will move from a large headwind to a slight tailwind for global activity (Chart I-7, top panel). Mounting public capex also points toward a modest global recovery (Chart I-7, middle panel). Finally, the upturn in our Chinese reflation indicator, which incorporates both fiscal and monetary policy, points to a re-acceleration in U.S. capex intentions (Chart I-7, bottom panel). Global Liquidity Global liquidity conditions continue to improve and the global economy should soon respond within normal policy lags. 95% of central banks are loosening policy, which normally leads to an escalation in global activity (Chart I-8). The dominant central banks (the Federal Reserve, the European Central Bank and the Bank of Japan) will not tighten anytime soon. Inflation expectations in the U.S., the euro area and Japan stand at 1.9%, 1.1%, and 0.2%, respectively, well below levels consistent with a 2% inflation target. Moreover, U.S. core CPI has been perky, but both the ISM and the performance of transportation equities relative to utilities indicate that a deceleration in inflation is imminent (Chart I-9). Salaries are not yet inflationary either because U.S. real wages are growing in line with productivity (Chart I-9, bottom panel). In the euro area and Japan, realized core inflation remains at 1.0% and 0.5%, respectively, and supports the dovish message emanating from inflation expectations. Chart I-8Easier Global Policy Is Important Chart I-9If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief     Liquidity indicators are reflecting this accommodative policy setting. The growth of U.S. and European bank deposits has reaccelerated from 2.5% to 6%, a development linked to the exit of a soft patch (Chart I-10). Moreover, BCA’s U.S. Financial Liquidity Indicator is still moving higher and flashing a resurgence in the BCA Global Leading Economic Indicator (LEI), the ISM Manufacturing Index, commodity prices, and EM export prices (Chart I-11). Finally, U.S. and global excess money reinforce the message of BCA’s U.S. Financial liquidity Indicator (Chart I-12). Chart I-10Deposits Suggest The Worst Of The Slowdown Is Behind Us Chart I-11Continued Pick-Up In Financial Liquidity       The Fed will add to the supply of global liquidity by tackling the repo market’s seize-up. Depleting excess reserves and mounting financing needs among primary dealers resulted in the September surge in the Secured Overnight Financing Rate (SOFR). The Fed announced three weeks ago it would buy $60 billion per month of T-Bills and T-Notes, which will lead to a climbing stock of excess reserves. Higher excess reserves create a weaker dollar, stronger EM currencies and firming global PMIs (Chart I-13). Ultimately, EM currency strength eases EM financial conditions, which supports global growth (Chart I-13, bottom panel). Chart I-12Excess Liquidity Is Accelerating Chart I-13U.S. Excess Reserves Will Grow Again   Borrowing activity in Advanced Economies is showing signs of life. Bank credit is already responding to the drop in global yields, and global corporate bond issuance in September 2019 rose to $434 billion. In the U.S., new issues of corporate bonds have also reaccelerated (Chart I-14). Global Growth Indicators Crucial indicators of global economic activity are picking up on this improving fundamental backdrop. The list includes: A sharp takeoff in the annualized three-month rate of change of capital goods orders in the U.S., the Eurozone and Japan (Chart I-15, top panel). Improvement in this indicator precedes progress in the annual growth rate of orders and in capex itself. Chart I-14Borrowers Are Responding To Easier Financial Conditions Chart I-15Some Green Shoots Are Coming Through Chart I-16Positive Market Signals A significant upturn in the Philly Fed, Empire State, and Richmond Fed manufacturing surveys for October, which sends a positive signal for the ISM Manufacturing Index (Chart I-15, second panel). Moreover, the new orders and employment components of these surveys indicate that cyclical sectors of the economy will recover and the recent deterioration in employment conditions will be fleeting. A rebound in BCA’s EM economic diffusion index, which incorporates 23 variables. Such an increase usually precedes inflections in global industrial production (Chart I-15, bottom panel). An acceleration – both in absolute and relative terms - in the annual appreciation of Taiwanese stocks. A strong and outperforming Taiwanese equity market is a harbinger of firmer PMIs (Chart I-16, top two panels). A solid performance of EM carry trades financed in yen, European luxury equities, and the relative performance of global semiconductors, materials and industrial stocks, which signal stronger global PMIs (Chart I-16, bottom three panels). Bottom Line: The global economy will accelerate in Q1 2020. A melting probability of a “No-Deal” Brexit and a truce in the Sino-U.S. trade war will allow global uncertainty to recede. Concurrently, China’s economic slowdown is ending and global liquidity conditions are improving. The Dollar As The Arbiter Of Growth Chart I-17The Dollar Is A Counter-Cyclical Currency The dollar faces potent headwinds. The greenback is a countercyclical currency; a business cycle upswing and a weak USD go hand in hand (Chart I-17). The tightness of this relationship results from a powerful feedback loop: weak growth boosts the dollar, but the dollar’s strength foments additional economic slowdown. Global liquidity and activity indicators signal a weaker dollar because they point toward an economic recovery. BCA’s U.S. Financial Liquidity Index, which foresaw a deceleration in the greenback’s rate of appreciation, is calling for an outright depreciation (Chart I-18, top panel). The expanding holdings of securities on U.S. commercial banks’ balance sheets (a key measure of liquidity) corroborates this message. According to a model based on the U.S., Eurozone, Japanese and Chinese broad money supply, the USD should significantly depreciate in the coming 12 months (Chart I-18, third panel). Finally, our EM Economic Diffusion Index validates pressures on the greenback, especially against commodity currencies (Chart I-18, bottom two panels). Chart I-18Liquidity And Growth Indicators Point To A Weaker Dollar Growth differentials support this picture. Late last year, the stimulating effect of President Trump’s tax cuts allowed the U.S. to temporarily diverge from a weak global economy, but the U.S. manufacturing sector is now succumbing to the global slowdown. Once global growth snaps back, the U.S. is likely to lag behind as fiscal policy is becoming more stimulative outside the U.S. than in the U.S. Based on historical delays, this will continue to hurt the dollar (Chart I-19, top panel). Finally, the European economy generally outperforms the U.S. when China reflates, especially if Beijing’s push lifts the growth rate of M1 relative to M2, a proxy for China’s aggregate marginal propensity to consume (Chart I-20). Europe’s greater cyclicality reflects is larger exposure to both trade and manufacturing compared with the U.S. Chart I-19A Global Growth Convergence Will Hurt The Dollar Chart I-20European Growth To Rise Vis-A-Vis The U.S.   The greenback is expensive and technically vulnerable, which compounds its cyclical risk. The trade-weighted dollar is at a 25% premium to its purchasing power parity equilibrium (PPP), an overvaluation comparable to its 1985 and 2002 peaks. Moreover, our Composite Technical Indicator is overextended and has formed a negative divergence with the price of the dollar (see page 54, Section III). Finally, speculators are massively long the U.S. Dollar Index (DXY). Balance-of-payment flows also flash a significant downside in the dollar (Chart I-21). The U.S. current account deficit stands at 2.5% of GDP, but it is widening in response to the dollar’s overvaluation and the White House’s expansive fiscal policy. Since 2011, foreign direct investments (FDI) have been the main driver of the dollar’s gyrations. Last year, net FDI surged in response to profit repatriations encouraged by the Tax Cuts and Jobs Act of 2017, while portfolio flows stayed in neutral territory. This regulatory change had a one-off impact and FDI will begin to dry out. Therefore, financing the widening current account deficit will become harder. Finally, after years in the red, net portfolio flows into Europe have turned positive (Chart I-21, bottom panel). The USD’s depreciation will ease global financial conditions and supports growth further. In this context, interest rate differentials are noteworthy. The two-year spread in real rates between the U.S. and the rest of the G-10 has fallen significantly since October 2018. Reversals in real rates herald a weaker dollar, especially when it faces valuation, technical and flow handicaps. Moreover, European five-year forward short rate expectations are near record lows. If global growth can stabilize, then the five-year forward one-month OIS will pick up, especially relative to the U.S. An uptick will boost the EUR/USD pair and hurt the dollar (Chart I-22). Chart I-21Balance-Of-Payments Dynamics Turning Against The USD Chart I-22Relative Long-Term Rate Expectations And The Euro   The three most pro-cyclical currencies in the G-10 – the AUD, NZD and SEK - strengthen the most when BCA’s Global LEI bottoms but global inflation slows (Chart I-23). The GBP will likely generate a much stronger-than-normal performance next year. Cable trades at a 22% discount to PPP. It is also 19% cheap versus short-term interest rate parity models. The absence of a “No-Deal” Brexit should allow these risk premia to dissipate and the pound to recover. The CAD is also more attractive than Chart I-23 implies. The loonie is trading 10% below its PPP, and the USD/CAD often lags the EUR/CAD, a pair that has broken down (Chart I-24). Chart I-23Currency Performance As A Function Of Growth And Inflation Chart I-24EUR/CAD Flashing A Bearish USD/CAD Signal Bottom Line: A rebound in the global manufacturing sector next year will hurt the USD. The dollar is particularly vulnerable because growth differentials between the U.S. and the rest of the world have melted, the greenback is expensive, balance-of-payment dynamics are deteriorating and interest rate differentials are becoming less supportive. The USD’s depreciation will ease global financial conditions and supports growth further. Additional Investment Implications Bond Yields Have More Upside While the short-term outlook for bonds remains murky, the 12- to 18-month outlook is unambiguously bearish. The BCA Bond Valuation Index is still consistent with much higher U.S. yields in the next 12-18 months (see Section III, page 51). BCA’s Composite Technical Indicator for T-Notes is massively overbought and sentiment, as approximated by the Long-Term Interest Rates component of the ZEW survey, is overly bullish (Chart I-25). Thus, bonds represent an attractive cyclical sell. The Fed will not cut rates aggressively enough for bonds to ignore these valuation and technical risks. Treasurys have outperformed cash by 7.5% in the past year. Based on historical relationships, the Fed needs to cut rates to zero for bonds to beat cash in the coming 12 months (Chart I-26). After this week’s Fed cut to 1.75%, our base case is none to maybe one more rate cut. Chart I-25Sentiment Points To Yield Upside Chart I-26The Fed Must Cut To Zero For T-Notes To Outperform Cash Further   Bond yields will need a recession to move lower. The deviation of 10-year Treasury yields from their two-year moving average closely tracks the Swedish Economic Diffusion Index (Chart I-27, top panel). Sweden, a small, open economy highly levered to the global industrial cycle, is a good gauge of the global business cycle. The broad weakness in the Swedish economy is unlikely to worsen unless the global slowdown morphs into a deep recession. Even if global growth remains mediocre, Sweden’s Economic Diffusion Index will rise along with yields. The expansion in securities holdings of U.S. commercial banks and the stabilization in China’s credit flows both support this notion (Chart I-27, bottom panel). Financial market developments also point to higher yields. Sectors that typically capture the momentum in the global economy are perking up. For example, bottoms in the annual performance of European luxury equities or Taiwanese stocks have preceded increases in yields (Chart I-28). Chart I-27Yields Have Upside Chart I-28Key Financial Market Signals For Yields   Stocks Will Outperform Bonds Our conviction is strengthening that equities will outperform bonds. The total return of the stock-to-bond ratio has upside. BCA’s Global Economic and Financial Diffusion Index has rallied sharply, which often precedes an ascent in the stock-to-bond ratio, both in the U.S. and globally (Chart I-29). Bonds are much more expensive than stocks, therefore, only a recession will allow stocks to underperform in the coming 12 to 18 months. The environment is positive for equities. BCA’s Monetary Indicator is very elevated and our Composite Sentiment Indicator shows little complacency toward stocks among investors (see Section III, page 47). Finally, the strength in the U.S. Financial Liquidity Indicator supports the S&P 500’s returns (Chart I-30). Chart I-29Cyclical Indicators Argue In Favor Of Stocks Over Bonds Chart I-30Liquidity Tailwind For The S&P 500   A few market developments are noteworthy. 55.6% of the S&P 500’s constituents have reported Q3 earnings, and 74% of those firms are beating estimates. Moreover, the market is generously rewarding firms with the largest positive earnings surprises. Additionally, the Value Line Geometric Index is forming a reverse head-and-shoulder pattern, while the relative performance of the Russell 2000 has formed a double bottom (Chart I-31). The environment also favors cyclicals relative to defensive equities. By lifting bond yields, stronger economic activity leads to a contraction in the multiples of defensives relative to cyclicals. The latter’s earnings expectations respond more positively to reviving economic activity, which creates an offset to climbing discount rates. As a result, cyclicals often outperform defensives when the stock-to-bond ratio increases, or after Taiwanese equities gain momentum (Chart I-32). Chart I-31Improving Equity Market Dynamics Chart I-32Favor Cyclicals Over Defensives   Compared to other equity markets, the U.S. faces the most challenges. Our model forecasts a 3% annual drop in the S&P 500’s operating earnings in June 2020, and the deviation of U.S. equities from their 200-day moving average has greatly diverged from net earnings revisions (Chart I-33). U.S. equities have already discounted a turnaround in earnings. Moreover, the S&P 500’s margins have downside, a topic covered by BCA’s Chief Equity Strategist Anastasios Avgeriou.4 Our Composite Margin Proxy, Operating Margins Diffusion Index and Corporate Pricing Power Indicator all remain weak (Chart I-34). Downward pressure on margins will limit how rapidly earnings respond when a rebound in global economic activity lifts revenues. Finally, the S&P 500 trades at a historically elevated forward P/E ratio of 18.4, the MSCI EAFE trade at a much more reasonable 14-times forward earnings. Chart I-33Headwinds For U.S. Stocks Chart I-34Headwinds For U.S. Margins   The tech sector will also weigh on the performance of U.S. equities relative to international stocks. Tech stocks represent 22.5% of the U.S. benchmark, compared with 9.7% for the euro area. Anastasios recently argued that software spending has remained surprisingly resilient despite the global economic slowdown; it will likely lag spending on machinery and structures when the cycle picks up.5 Consequently, tech earnings will lag other traditional cyclical sectors. Moreover, tech multiples will suffer when the dollar depreciates and bond yields rise (Chart I-35). As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to discount factors. Unaffected by those negatives, European equities will benefit most from the outperformance of stocks relative to bonds. A weak dollar will be the first positive for the common-currency returns of European equities. Valuations are the second tailwind. The risk premium for European equities is 300 basis points higher than for U.S. stocks. Moreover, U.S. margins will likely diminish relative to the Eurozone’s because of stronger unit labor costs in the U.S. Sector composition will also dictate the performance of European equities. Compared with the U.S., Europe is underweight tech and healthcare stocks, a defensive sector (Table I-1). Investors who favor Europe will also bet against these two sectors. Europe is a wager on the other cyclical sectors: materials, industrials, energy and financials. Chart I-35Tech P/Es Are At Risk Table I-1Europe Overweights The Correct Cyclicals   European financials are particularly attractive. Negative European yields are a major handicap for European financials, but this handicap is already reflected in their price. European banks trade at a price-to-book ratio of 0.6 versus 1.3 for the U.S. This discount should be narrowing, not widening. Yields are bottoming and European loan growth is contracting at a -2% annual rate relative to the U.S. versus -8.6% five years ago. Meanwhile, the annual rate of change of European deposits is in line with the U.S. The attraction of European banks comes from the outlook for their return on tangible equity. A model shows that three variables govern European banks’ ROE: German yields, Italian spreads and the momentum of the silver-to-gold ratio (SGR). German yields impact net interest margins, Italian spreads drive peripheral financial conditions and thus, loan generation in the European periphery, and the SGR tracks the global manufacturing cycle (silver has more industrial uses than gold, but is equally sensitive to real yields), which affects loan flows in the European core. This model logically tracks the performance of European banks and financials (Chart I-36). Our positive outlook on global growth and yields, along with the fall in Italian spreads, augurs well for cheap European financial equities and banks in particular. Commodities Our constructive stance on the global business cycle and yields, plus our negative view on the greenback, is consistent with higher industrial commodity prices. Copper looks particularly attractive. Speculators are aggressively selling the metal, whose price stands at an important technical juncture (Chart I-37). Chart I-36The Drivers Of RoE Point To Higher European Bank Stock Prices Chart I-37Cooper Is An Attractive Play On Global Growth   Chart I-38Favorable Technical Backdrop For Silver-To-Gold Ratio Finally, we have favored the SGR since late June. Silver is deeply oversold and under-owned relative to the yellow metal (Chart I-38). Consequently, silver’s greater industrial usage should be a potent tailwind for the SGR.6 Mathieu Savary Vice President The Bank Credit Analyst October 31, 2019 Next Report: November 22, 2019 - Outlook 2020   II. Back To The Nineteenth Century The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.7 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. The U.S.-China conflict will not lead to complete bifurcation of the global economy. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”8 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”9 Chart II-1Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.10 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart II-1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. In a multipolar world, the U.S. will not be able to exclude China from the global system. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart II-2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart II-2China’s Mean Reverting Narrative In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart II-3). Chart II-3The Beijing Consensus Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead To Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. Diagram II-1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram II-1Trade War In A Bipolar World However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.11 History teaches us that trade occurs even amongst rivals and during wartime. The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.12 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart II-4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart II-4The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart II-5). This is for three reasons: Chart II-5Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.13 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. Diagram II-2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram II-2Trade War In A Multipolar World Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.14 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts II-1 and II-4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”15 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”16 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”17 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.18 Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.19 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart II-6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart II-7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart II-6The Allies Traded With Germany ... Chart II-7… Right Up To WWI   Chart II-8Japan And U.S. Never Downshifted Trade A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart II-8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram II-2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart II-9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart II-9The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart II-10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart II-11). Chart II-10Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group III. Indicators And Reference Charts The S&P 500 is making marginally new all-time highs. Seasonality is becoming very favorable for stock prices. However, our U.S. profit model continues to point south and expanding multiples have already driven this year’s equity gains. The S&P 500 has therefore already priced in a significant improvement in profits. Further P/E expansion will be harder to come by with bond yields set to rise. Thus, until the dollar falls and creates another tailwind for profits, stocks will not be as strong as seasonality suggests and will only make marginal new highs. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Until global growth bottoms and boosts the earnings forecasts of our models, stock gains will stay limited. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. continues to improve. This same indicator has recently turned lower in Japan. Meanwhile, it is deteriorating further in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth has picked up around the world, and global central banks continue to conduct very dovish policies. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Also, our BCA Composite Valuation index is still improving. As a result, our Speculation Indicator is back in the neutral zone. 10-year Treasury yields continue to rise, but they remain very expensive. Moreover, both our Bond Valuation Index and our Composite Technical Indicators are still flashing high-conviction sell signals. If the strengthening of the Commodity Index Advance/Decline line results in higher natural resource prices, then, inflation breakevens will also climb meaningfully. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Weak global growth has been the key support for the dollar in recent months. On a PPP basis, the U.S. dollar remains extremely expensive. Additionally, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. Moreover, the U.S. current account deficit has begun to widen anew. This backdrop makes the dollar highly vulnerable to a rebound in global growth. In fact, a breakdown in the greenback will be the clearest signal yet that global growth is rebounding for good. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-23Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1   Please see The Bank Credit Analyst "September 2019," dated August 29, 2019, available at bca.bcaresearch.com 2   Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 3   Please see The Bank Credit Analyst "August 2019," dated July 25, 2019, available at bca.bcaresearch.com 4   Please see U.S. Equity Strategy Special Report "Peak Margins," dated October 7, 2019, available at uses.bcaresearch.com 5   Please see U.S. Equity Strategy Weekly Report "Follow The Profit Trail," dated October 15, 2019, available at uses.bcaresearch.com 6   Please see Foreign  Exchange Strategy Weekly Report "On Money Velocity, EUR/USD And Silver," dated October 11, 2019, available on fes.bcaresearch.com 7   Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 8   Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 9   See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).  10  The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 11   Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 12   We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own.  13   See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 14   Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 15   See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 16   Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 17   Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 18  Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia.  19  See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.