Global

Highlights The U.S.-Sino trade war is taking a dangerous turn, but the U.S. should avoid a recession until 2022. Global growth will bottom in early 2020. The Fed is set to cut rates two to three times in the next year. Safe-haven bonds have more tactical upside, but will perform poorly on a cyclical basis. Long-term investors should use the next six to nine months to offload their corporate bonds. Equities will be volatile for the rest of 2019; a breakout is forecast for 2020. Long-term investors should favor stocks over bonds, and international stocks over U.S. ones. Feature The yield curve has become the punch line of late-night shows, triggered by the 2-/10-year yield curve inversion in early August. Recession fears have hit the front page. There are good reasons for the mounting concern. Historically, yield curve inversions have done an excellent job forecasting recession. The trade war between the U.S. and China is intensifying at an alarming speed. Moreover, global government bond yields are dipping to all-time lows. Additionally, the global ZEW and PMIs are depressed, while the global production of capital goods and machinery is contracting (Chart I-1). Despite this backdrop, the odds of a U.S. recession are overstated. Consumers in the U.S. and other advanced economies are healthy, the U.S. Federal Reserve and other major central banks are easing, and global financial conditions are supporting growth. We expect stocks to break out of their volatile period of consolidation early next year. Bond yields should rise later this year, but it is too early to stand in front of their downward trend. Finally, long-term investors should use any additional narrowing in credit spreads to lighten their exposure to corporates. U.S. Recession Odds Are Low The yield curve signal is not as dire as the headlines suggest. The inversion is incomplete; the curve is inverted up to the five-year mark and beyond that point, it steepens again. If the yield curve foreshadows a recession, then its slope would be negative across all maturities (Chart I-2). Chart I-1The List Of Worries Is Long   The consumer sector is doing well despite the global growth slowdown. Real retail sales, excluding motor vehicles, are growing at 4.4% and have quickly recovered from this past winter’s government shutdown. Meanwhile, retailers such as Walmart, Target, Home Depot and Lowe’s are reporting strong numbers. Three factors insulate consumer spending from global woes. First, household disposable income is expanding at a healthy 4.7% pace, courtesy of a tight labor market. Secondly, household balance sheets are robust. Household debt-servicing costs only represent 9.9% of disposable income, the lowest reading in more than four decades (Chart I-3, first panel). According to a December BIS paper, debt-servicing costs are one of the best forecasters of recessions.1 Additionally, household debt relative to GDP and to household assets is at 16- and 34-year lows, respectively (Chart I-3, second and third panel). Thirdly, the U.S. savings rate, which stands at 8.1%, already offers a cushion against adverse shocks and has limited upside. The corporate sector also displays some easily overlooked positives. So far, the PMIs and capex growth are still in mid-cycle slowdown territory. Meanwhile, debt loads have never provided an accurate recessionary signal. Since the end of the gold standard, recessions have always materialized after debt-servicing costs as a share of EBITDA rose two to four percentage points above their five-year moving average. We are nowhere near there (Chart I-4). Chart I-3Consumer Balance Sheets Are Very Robust Chart I-4Corporate Debt Is Not In Recessionary Territory   Nevertheless, we will remain vigilant on the capex trend. Corporate investment may not indicate a recession, but the escalating trade war with China will hurt capex intentions. Even if capex contracts, as in 2016, the economy can still avoid a recession. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. Housing is showing some positive signs after subtracting from GDP in the past six quarters. The NAHB Housing Market Index is recovering smartly from its plunge last year and homebuilder stocks have been outperforming the S&P 500 since October 2018 (Chart I-5). Meanwhile, the 139-basis point collapse in mortgage rates since November 2018 is finally impacting the economy. Mortgage demand is surging, according to the Fed’s Senior Loan Officers Survey. The MBA mortgage applications data corroborate this observation. As a result, both existing home sales and residential investment are trying to bottom (Chart I-6). Chart I-5Leading Indicators Of Residential Activity Are Improving Chart I-6Positive Signs For Residential Activity     The liquidity of the U.S. private sector is also strengthening. Deposit growth has reaccelerated after falling to near recessionary levels (Chart I-7) and the non-financial, private sector’s cash holdings are again increasing faster than debt. Furthermore, bank credit is expanding. Chart I-7The Private Sector Is Accumulating Liquidity Waiting For The Global Economy To Bottom Global growth should bottom by early 2020. Thus, while the U.S. economy should avoid a recession, any distinct re-acceleration will wait until next year. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. The trade war between the U.S. and China is intensifying. Chinese activity has not yet bottomed but policymakers will be increasingly forced to react. However, the global inventory down cycle is advanced, and in Europe, domestic activity indicators are holding up despite the continued deterioration in external and industrial conditions. Trade War The uncertainty created by the Sino-U.S. trade war is hurting global growth. On August 1, U.S. President Donald Trump announced a 10% tariff on the remaining $300 billion of Chinese exports to the U.S. The tariffs are phased in: $112 billions of goods will be taxed on September 1 while $160 billion will be hit on December 15. Unsurprisingly, a vicious circle of retaliation has been unleashed as China imposed a tariff ranging from 5% to 10% on U.S. goods last Friday, to which Trump immediately responded with a tariff hike from 25% to 30% on the $250 billion batch of goods and from 10% to 15% on the $300 billion batch slated to come into place September 1 and December 1. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. A resumption in talks between Beijing and Washington in September will offer little solace to investors. Even if President Trump is pressured by the stock market and the U.S. electoral calendar to settle for what Beijing is offering, it is not clear that President Xi Jinping will accept a deal. As BCA’s Chief Geopolitical Strategist Matt Gertken discusses in Section II, the two superpowers are locked in a multi-decade geopolitical rivalry and the Hong Kong protests and tensions over Taiwan could move the talks off track. China’s Challenges China’s economy has yet to bottom convincingly. So far, Chinese reflation has been weaker than anticipated. Given that stimulus has not been forceful, the uncertainty produced by the trade war and the illiquidity created by bloated balance sheets is still dragging down China’s marginal propensity to consume (Chart I-8). However, this propensity to spend has little downside, if the past 10 years are any indication. Chinese infrastructure and equipment investment needs to be revived. They are shouldering the bulk of the decline in economic activity and have slowed to an annual pace of 2.8% and -2.1%, respectively. Residential investment is expanding at a 9.4% annual rate (Chart I-9), but according to Arthur Budaghyan, BCA’s Chief Emerging Markets Strategist, even this sector’s strength could be an illusion. Chinese property developers are starting projects to raise funds via pre-sales. However, they are not completing nearly as many projects as they have started.2 Chart I-8A Falling Marginal Propensity To Spend Means More Stimulus Is Needed   We are not yet ready to give up on Chinese stimulus as the economy is on the verge of a deflationary spiral that could push debt-to-GDP abruptly higher. The following developments support this view: The statement following the July Politburo meeting showed a greater willingness to stimulate economic activity, as long as it does not add to the property bubble. Producer prices are again deflating. Contracting PPIs often unleash vicious circles as they push real rates higher and hurt investment, which foments additional price declines. Retail sales are slowing and the employment components of the manufacturing and non-manufacturing PMIs have fallen to 47.1 and 48.7, respectively. China’s economy needs to be insulated from the intensifying trade war with the U.S. or the deteriorating labor market will dampen consumer spending even more. We expect more tax cuts, more credit growth, and more issuance of local government special bonds to finance government spending, following China’s 70th anniversary celebrations on October 1. As Chart I-10 illustrates, an acceleration in total social financing will ultimately lift EM PMIs as well as Asian and European exports. Inventory Cycle The inventory cycle is very advanced. Inventories in the U.S., China and euro area are depleting (Chart I-11). Inventories cannot fall forever, especially when global monetary policy is increasingly accommodative and fiscal policy is loosened. Chart I-10More Chinese Stimulus Will Eventually Support Global Growth Chart I-11The Inventory Purge Is Advanced   Global activity can rebound if the inventory adjustment ends. Inventory fluctuations help drive the Kitchin cycle, a 36-40 month oscillation in activity. According to BCA’s Chief Global Strategist, Peter Berezin, the current slowdown is nearing 18 months, the typical length of a down oscillation in these cycles (Chart I-12).3 Europe     The manufacturing-heavy euro area will benefit when the global industrial cycle bottoms, but domestic tailwinds are also emerging. European deposits accumulation is quickening, driven by households (Chart I-13, top panel). Meanwhile, the European credit impulse has recovered thanks to the fall in both non-performing loans and borrowing costs (Chart I-13, bottom panel). Moreover, consumer spending is healthy as household balance sheets are improving and wage growth is accelerating to a 3.2% annual pace. Finally, last month we highlighted that the euro area fiscal thrust is set to increase by 0.7% of GDP this year.4 Fiscal easing appears set to expand as Germany and Italy study support packages. Finally, the Italian political uncertainty is receding as the Five Star Movement and the Democratic Party have agreed to form a coalition government. Chart I-12The Three-Year Cycle Is Also Advanced Chart I-13Some Ignored Improvements In Europe   At the moment, the biggest risk for Europe is the significant probability of a No-Deal Brexit. After the recent decision to prorogue Parliament, Matt Gertken raised his probability of a No-Deal Brexit to one third from 20%.Such an event would negatively impact Dutch, German and French exports, which could scuttle any improvement in Europe. Adding It Up The combined effects of more Chinese stimulus in the fourth quarter, an impending end to the global inventory drawdown, and an endogenous improvement in Europe, all should ultimately outweigh the negatives created by the U.S.-Sino trade war. Moreover, global financial conditions are easing (Chart I-14). Therefore, the fall in global bond yields should push the G-10 12-month credit impulse higher (Chart I-14, bottom panel). Lower oil prices should also help G-10 consumers. Early indicators support this assessment. BCA’s Global Leading Economic Indicator has been slowly bottoming, and according to its diffusion index, it will soon move higher (Chart I-15, top panel). Moreover, Singapore’s container throughput is tentatively stabilizing, while our Asian EM Diffusion Index is improving, albeit from depressed levels (Chart I-15, second panel). Finally, ethylene and propylene prices are rallying with accelerating momentum (Chart I-15, third and fourth panels). Chart I-14Easier Financial Conditions Favor Credit Growth Chart I-15Some Growth Indicators Are Stabilizing   Bottom Line: The U.S. economy will probably slow further in the coming months, but it will not enter into recession anytime soon. Neither debt nor consumers pose problems, the housing sector is turning the corner and the private sector’s liquidity position is strengthening. Meanwhile, global activity is trying to bottom, but any improvement will be delayed by the latest round of trade tensions. However, global policymakers are responding, thus global growth should improve by early 2020. Fed Policy: More Cuts Expected Chart I-16A Liquidity Crunch In The Interbank Market? Our base case is that the Fed will cut rates twice more in the coming nine months. In the tails of the probability distribution, three supplementary cuts are more likely than only one additional cut. Paradoxically, liquidity considerations support our Fed view. A recurring theme in our research is the improvement in global liquidity indicators such as excess money, deposit growth and our financial liquidity index.5 However, these indicators are not able to boost growth because of an important technical consideration. What might be classified as excess reserves by the Fed may not be free reserves. Higher Supplementary Leverage Ratios under Basel III rules require commercial banks to hold greater levels of excess reserves to meet their mandatory Tier 1 capital ratios. Since the Fed’s balance sheet runoff results in falling excess reserves, the decline in reserves may have already created some illiquidity in the interbank system. Global central banks have been divesting from the T-bill market, which is worsening the decline in excess reserves. They have parked their short-term funds at the New York Fed’s Foreign Repurchase Agreement Pool (Foreign Repo Pool) which limits the availability of reserves in the banking system (Chart I-16).6 These dynamics increase the cost of hedging the dollar for foreign buyers of U.S. assets. When reserves fall below thresholds implied by Basel III regulations, global banks lose their ability to use their balance sheets to conduct capital market transactions. Without this necessary wiggle room, they cannot arbitrage away wider cross-currency basis swap spreads and deviations of FX forward prices from covered interest rate parity. For foreign investors, the cost of hedging their FX exposure increases. Together with the flatness of the U.S. yield curve, hedged U.S. Treasurys currently yield less than German Bunds or JGBs (Table I-1). Chart I-17Declining Excess Reserves Hurt Risk Assets And Growth Lower excess reserves and higher hedging costs have been bullish for the USD and negative for the global economy. Instead of buying hedged Treasurys, foreigners purchase U.S. assets unhedged (agency and corporate bonds, not Treasurys). Thus, falling excess reserves have been correlated with a stronger dollar, softer global growth and weaker EM asset and FX prices (Chart I-17). This adverse environment has accentuated the downside in Treasury yields and flattened the yield curve (Chart I-17, bottom panel). Going forward, these problems should intensify. The Treasury will issue over US$800 billion of debt by year-end to replenish its cash balance and finance the bulging U.S. budget deficit. Primary dealers will continue to plug the void left by foreigners and will purchase the expanding issuance (Chart I-18). In the past year, primary dealers have already increased their repo-market borrowing by $300 billion to finance their inventories of securities. They will need to expand these borrowings, which will further lift the cost of hedging U.S. assets. Thus, foreign investors faced with $16 trillion of assets with negative yields will buy more U.S. assets on an unhedged basis. The dollar will rise and global growth conditions will deteriorate. The Fed will have to cut rates two to three more times, otherwise the dangerous feedback loop described above will take hold. These cuts are more than domestic economic conditions warrant. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. The end of the balance sheet runoff is a step in the right direction, but it will not be enough. The BCA Financial Stress Index and our Fed Monitor are consistent with this view (Chart I-19). Moreover, the intensifying trade war is hurting the outlook for growth, inflation expectations and the stock market. Chart I-18A Large Inventory Build Up By Primary Dealers Chart I-19Two To Three More Cuts Are Coming   Investment Implications Government Bonds We have revised our position on an imminent end to the bull market. We do expect bond yields to be higher in 12 months, but for now the global economy has too many risks to time a bottom in yields. The cyclical picture for bonds is bearish. Treasurys have outperformed cash by 8% in the past year, a performance normally associated with a fed fund rate that is 200 to 300 basis points below what markets anticipated 12 months ago (Chart I-20). In order for Treasurys to continue outperforming cash, the Fed must cut rates to zero next year. Nonetheless, a U.S. recession is not in the offing and the global economy should perk up by early 2020. At most, the Fed will validate current rate expectations of 96 basis points of cuts. Chart I-20The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year Valuations are also consistent with Treasurys delivering negative returns in the next 12 months. According to the BCA Bond Valuation Index, Treasurys are extremely overvalued. Moreover, real 10-year yields are two standard deviations below the three-year moving average of real GDP growth, a proxy for potential GDP (Chart I-21). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. Technicals also point to poor 12-month prospective returns. The 13-week and 52-week rates of change in yields are consistent with tops in bond prices (Chart I-22). Positioning is also very stretched, as highlighted by the J.P. Morgan Duration Survey, the Bank of America Merrill Lynch Investors Survey, ETF flows, and government bonds futures and options holdings of asset managers. As a result, our Composite Technical Indicator is very overbought (Chart I-22, bottom panel). Chart I-21U.S. Bonds Are Very Expensive ... Chart I-22... And Very Overbought   The quickening pace of accumulation of securities on bank balance sheets also points to higher yields in 12 months (Chart I-23). As banks stockpile liquid assets, they accumulate more juice to fuel future lending. However, the rising cost of hedging FX exposure is bullish for the dollar. Hence, increasing Treasury holdings will not lift yields until the Fed cuts rates more aggressively. We are reluctant to recommend shorting / underweighting bonds. As Chart I-24 illustrates, mounting uncertainty over economic policy anchors U.S. yields. Last week’s round of tariff increases, along with the Brexit saga, suggests that the uncertainty has not yet peaked. Chart I-23A Coiled Spring Chart I-24Uncertainty Is Keeping Global Bonds Expensive   The collapse in German yields is also not finished. The fall in bund yields to -0.7% has dragged down rates worldwide as investors seek positive long-term returns. In response, the U.S. 10-year premium dropped to -1.1%. Historically, bunds end their rally when yields decline 120 basis points below their two-year moving average (Chart I-25). If history is a guide, German yields could bottom toward -1%, which is in line with Swiss 10-year yields. The 1995 experience also argues against an imminent end to the bond rally. In a recent Special Report, BCA’s U.S. Equity Strategy service highlighted the parallels between today’s environment and the aftermath of the December 1994 Tequila Crisis.7 In that episode, global growth troughed and the Fed cut rates three times before the U.S. ISM Manufacturing Index bottomed in January 1996. Only then did Treasury yields turn higher (Chart I-26). A similar scenario could easily unfold. Chart I-25More Downside For German Yields Chart I-26Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More   EM assets are vulnerable and could spark a last stampede into U.S. Treasurys. Investors of EM fixed-income products have not yet capitulated. EM assets perform poorly when global growth is weak, dollar funding is hard to come by and trade uncertainty is rising. Yet, yields on EM local-currency bonds have fallen, indicating little selling pressure. Rather than dispose of their EM holdings, investors have hedged their EM exposure by selling EM currencies. Therefore, EM bonds are rallying with EM currencies falling (Chart I-27), which is a rare occurrence. Recent cracks in EM high-yield bonds and the breakdown in EM currencies suggest investors will not ignore the trade war for much longer. The ensuing flight to safety should pull down Treasury yields. Chart I-27A Rare Occurrence BCA’s Cyclical Bond Indicator has yet to flash a buy signal, which will only happen when the indicator moves above its 9-month moving average (Chart I-28). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. As a corollary, we remain positive on gold prices and expect the yellow metal to move to $1,600 in the coming months. Chart I-28BCA Cyclical Bond Indicator: Don't Sell Yet Corporate Bonds Chart I-29Corporate Bond Fundamentals Are Worsening The long-term outlook for corporate bonds is deteriorating enough that long-term investors should use any rally to lighten their exposures. However, on a six- to nine-month horizon, stresses will probably remain contained. A significant deterioration in corporate health will hurt this asset class’s long-term returns. Recent data revisions pushed GDP and productivity well below previous estimates. This curtailed corporate profitability, lifted debt-to-cash flow ratios, and hurt interest coverage measures. BCA’s Corporate Health Monitor is flashing its worst reading since the financial crisis. Moreover, the return on capital is at its lowest level in this cycle. Historically, these developments have pointed to higher default rates and spreads (Chart I-29). Worryingly, average interest coverage and profitability levels are distorted. Tech firms only account for 8% of the U.S. corporate bond universe, yet they represent 19% of cash flows generated by the U.S. corporate sector. Outside the tech sector, cash generation is poorer than suggested by our Corporate Health Monitor. This will amplify losses when the default cycle begins. The poor quality of bond issuance in the past 8 years will also hurt recovery rates when defaults rise. Since then, junk bonds constitute 10% of overall issuance, and BBB-rated bonds represent 42% of investment-grade issues. Historical averages are 9% and 27%, respectively. Additionally, covenants have been particularly light in the same period. Investors with horizons of one year or less still have a window to own corporate bonds. Moreover, since the deviation of corporate debt-servicing costs as a percentage of EBITDA remains well below historical trigger points, an imminent and durable jump in spreads is unlikely. Within the corporate universe, BCA’s U.S. Bond Strategy service currently favors high-yield to investment-grade bonds.8 Breakeven spreads in the junk space are much more rewarding than those offered by investment-grade issues (Chart I-30). Equities We expect the S&P 500 to remain volatile and below 3,000 for the rest of 2019. Early next year, an upside breakout will end this period of churn. The S&P will probably soon test the 2,700 level. Technically, the selling is not exhausted. The number of stocks above their 40-, 30- and 10-week moving averages have formed successively lower highs and are not yet oversold (Chart I-31). Furthermore, the Fed is unlikely to deliver a dovish surprise in September. Fed Chairman Jerome Powell’s recent speech at Jackson Hole suggests that the Fed needs to see more pain before moving ahead of the curve. Chart I-30Short-Term Investors Should Favor Junk Over Investment Grade Issues Chart I-31This Correction Can Run Further   Once stocks stabilize, the subsequent rebound will not lead to an immediate breakout this year. Yields will move up when growth picks up or if President Trump becomes less combative on trade. However, falling interest rates have been a crucial support for stock prices in 2019. As the 1995-1996 experience shows, when the ISM turned up, the S&P 500 did not gain much traction. Higher yields pushed down multiples even as earnings estimates strengthened. We are more positive on the outlook for stocks next year with BCA’s Monetary Indicator pointing to higher stock prices (see Section III). Moreover, bear markets materialize only when a recession is roughly six to nine months away (Chart I-32). The S&P still has time to rally because we do not anticipate a recession until early 2022. Chart I-32No Recession, No Bear Market Chart I-33Better Prospects For Non-U.S. Stocks Cyclical investors should move their equity holdings outside the U.S. International markets are comparatively cheap (Chart I-33, top panel). Moreover, a rebound in global growth early next year is congruent with U.S. underperformance. Finally, our earnings models forecast an end to the deterioration of European profit growth in September 2019, but not yet in the U.S. (Chart I-33, bottom two panels). Stocks should outperform bonds on a long-term basis. According to the BCA Valuation Index, U.S. stocks are extremely expensive (see Section III). Our valuation indicator would be as elevated as in 2000 if interest rates were not so depressed today. As Peter Berezin showed in BCA’s Global Investment Strategy service, based on current valuation levels, investors can expect 10-year returns of 3.0%, 4.5%, 11.9% and 7.4% for the U.S., euro area, Japan and EM equities, respectively.9 This is not appealing. Nonetheless, long-term equity expected returns are superior to bonds. If held to maturity, they will return 1.5%, -0.7%, and -0.3% annually in the U.S., Germany and Japan, respectively. Practically, long-term investors should favor the rest of the world over the U.S. Local-currency expected returns are higher outside the U.S., and the dollar will decline during the next 10 years. As our Foreign Exchange Strategy service recently highlighted, the dollar is very expensive on a long-term basis.10 Exchange rates strongly revert to their purchasing-parity equilibria in such investment horizons. The growing U.S. twin deficit and the strong desire of reserve managers to diversify out of the greenback will only exacerbate the dollar’s decline. Mathieu Savary Vice President The Bank Credit Analyst August 29, 2019 Next Report: September 26, 2019   II. Big Trouble In Greater China The chance of a U.S.-China trade agreement by November 2020 is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities.   “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart II-1). Chart II-1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. The same pattern played out on August 23 when President Trump responded to China’s retaliatory tariffs by declaring he would raise tariffs to 30% on the first half of imports and 15% on the remainder by December 15. Within a single weekend he softened his rhetoric and said he still wanted a deal. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart II-2) – an actual recession would consign him to history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart II-3). This leaves him less room for maneuver going forward. The fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart II-4). Chart II-3China's Gradual Stimulus Yet To Revive Global Economy Chart II-4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus   The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart II-5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart II-6). Chart II-5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart II-7). Chart II-7Trump's Fiscal Policy Undid His Trade Policy   The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop (Chart II-8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart II-8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not yet closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.11 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,12 and will the outcome derail the trade talks? The biggest question in the trade talks is no longer Trump, but Xi. Bottom Line: Global economic growth is fragile and President Trump has only rhetorically retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table II-1). Many of these concessions have been postponed as a result of Trump’s punitive measures. It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. Chart II-9China's Ultimate Economic Constraint China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “respect” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point, mutual respect, is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart II-9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has largely been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart II-10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. Chart II-10Creative Destruction In China These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart II-11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart II-11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, and the  extent of tariff rollback which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram II-1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart II-12A & II-12B).   A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart II-13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing rotating troops into the city and openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart II-14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart II-14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. Chart II-15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart II-15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart II-16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart II-17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart II-18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature.   Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart II-19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time.   While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart II-20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart II-21).   This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart II-22). A deterioration in this region has global consequences. Chart II-22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward.  Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken Vice President Geopolitical Strategy   III. Indicators And Reference Charts The S&P 500 correction is likely to deepen a bit further. A move toward 2700 remains our base case scenario. Short-term oscillators have not yet reached capitulation levels and the Sino-U.S. trade war remains a source of risks, especially as the Chinese side is unlikely to provide any strong concessions until October. However, we still do not expect a deeper correction to unfold. In other words, equities remain stuck in a trading range for the remainder of the year. Our Revealed Preference Indicator (RPI) continues to shun stocks. 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. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. Beyond this year, the outlook remains constructive of stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate 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. The WTP therefore argues that investors are still looking to buy the dips in the U.S. and in Japan, which limits the downside in those markets. Yields have collapsed, money growth has picked up, and global central banks are cutting rates in unison. As a result, our Monetary Indicator points to the most accommodative global monetary backdrop since early 2015. Moreover, our Composite Technical Indicator is improving and continues to flash a buy signal. In 2015, it was deteriorating after having hit overbought territory. Therefore, unlike four years ago, equities are more likely to avoid the gravitational pull created by their overvaluation, especially as our BCA Composite Valuation index is in fact improving thanks to lower bond yields.  According to our model, 10-year Treasurys have not been this expensive since late 2012. Back then, this level of overvaluation warned of an impending Treasury selloff. Moreover, our technical indicator is now deeply overbought. So are various rate-of-change measures for bond prices. While none of those indicators can tell you if yields will move up in the next few weeks, they do argue that the risk/reward of holding bonds over the coming year is extremely poor. That being said, we are closely monitoring the recent breakdown in the advanced/decline line of commodities, which might herald another down-leg in commodity prices, and therefore, in bond yields as well. On a PPP basis, the U.S. dollar is only growing ever more expensive. Additionally, despite the dollar’s recent strength, our Composite Technical Indicator has lost enough momentum that the negative divergence we flagged last month remains in place. It is worrisome for dollar bulls that despite growing uncertainty and a deteriorating global economy, the euro is not breaking down. If the dollar’s Technical Indicator deteriorates further and falls below zero, the momentum-continuation behavior of the greenback will likely kick in. The USD would suffer markedly were this to happen. 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-22Euro/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       Claudio Borio , Mathias Drehmann, Dora Xia, "The financial cycle and recession risk," BIS Quarterly Review, December 2018. 2       Please see Emerging Markets Strategy Special Report "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, available at ems.bcaresearch.com 3       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com 4       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 5       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 6       For an explanation of the mechanics of the FRP, please see NY Fed’s website: https://www.newyorkfed.org/aboutthefed/fedpoint/fed20 7       Please see U.S. Equity Strategy Special Report "Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse," dated August 19, 2019, available at uses.bcaresearch.com 8       Please see U.S. Bond Strategy Weekly Report "The Trump Interruption," dated August 13, 2019, available at usbs.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Please see Foreign Exchange Strategy Special Report, “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 11     Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 12     Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

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

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