Global

Highlights We spent nearly all of last week engaged in dialogue with clients: Over the course of a dozen face-to-face meetings, and multiple follow-up questions, we learned that crowding out is a real phenomenon. The Fed and trade tensions were essentially all that people wanted to discuss. We’re expecting a 25-basis-point rate cut in July, but our investment recommendations have not changed: We remain bullish on risk assets and bearish on Treasuries, and we continue to recommend that investors maintain below-benchmark duration positioning. Feature It turns out that you really can’t fight the Fed. Not when meeting with investors right now, anyway, as its impending moves dominated our discussions with several U.S.-based clients last week. We expect monetary policy will be Topic A on our meetings schedule this week and next, especially if the plot thickens after the FOMC releases its updated Summary of Economic Projections (“the dots”) and markets mull over Wednesday’s post-meeting statement and press conference. This report covers our recent exchanges with investors on the points that came up most often. Chart 1Healing, If Not Yet Fully Healed Q: How likely is it that the Fed will cut rates? We think a rate cut at the FOMC meeting beginning tomorrow is unlikely. Fed officials only revealed that they were seriously contemplating the idea recently, and it would feel rather sudden if they followed through so soon, especially when the Mexican tariff cloud has lifted, economic data have been reasonably firm and financial conditions are still easing (Chart 1). We pay particularly close attention when Fed speakers all start singing from the same sheet, though, and the prepared-to-adjust-the-target-range-as-necessary refrain is signaling a rate cut. Our base case is that changes in the post-meeting statement and the updated dots will point in the direction of a cut at the next FOMC conclave at the end of July. Q: Why has the Fed changed its tune so much since mid-December? We view the Fed’s evolution from a tightening bias to an easing bias as having unfolded in three distinct stages. The first stage occurred in early January, following the sharp fourth-quarter selloff in equities and corporate bonds. The decline in stock prices amounted to a meaningful decline in household wealth, the sudden widening in bond spreads heralded higher debt-service costs for corporations and consumers, and the surge in mortgage rates caused several would-be homebuyers to lose their nerve (Chart 2). With the accumulated tightening in financial conditions equating to at least one, if not two, 25-basis-point hikes in the fed funds rate, additional hikes would have amounted to piling on, and the Fed opted to move to the sidelines for perhaps a six-month stay. Financial conditions are still tighter than they were before the fourth-quarter selloff, but they’ve eased quite a bit. Chart 2The Rate Backup Spooked Homebuyers, But They'll Be Back The Fed signaled an even lengthier pause in March, bemoaning the risk of too-low inflation expectations, at a time when global growth was already slumping (Chart 3). It seemed to us that it began to worry about the prospect of entering the next recession with inflation expectations below 2%, from which it would not be able to lower the real fed funds rate below -2%. Inflation expectations of 2.5%, on the other hand, would support a real fed funds rate of -2.5%, providing the Fed with additional firepower to restart the economy. The post-meeting dots removed two full rate hikes from the median voter’s terminal-rate projection, and appeared to stretch the Fed’s pause from six months to twelve. Chart 3As Global Trade Goes, So Goes Global Growth Global trade facilitates global growth. Impediments to trade can cast a long shadow over the global economy, and the escalation of trade tensions provided the catalyst for the Fed’s latest dovish turn. Against a backdrop of uninspiring global growth, taking out some monetary policy insurance to protect against increasing trade frictions may well be a prudent course of action, especially in a low-inflation environment. At the moment, we assign slightly better than a 50% probability that the FOMC will cut the target rate at its July 30-31 meeting, but much could change between now and then. Q: What will happen if the Fed cuts rates? If the Fed cuts the fed funds rate in response to a rapidly weakening economy, risk assets will fare poorly. If the economy’s doing fine, and the rate cut is simply an insurance policy, the additional accommodation would give the economy an incremental boost, extending the longevity of the expansion. A longer runway for the business cycle, in turn, would mean longer (and bigger) bull markets in equities and spread product. In our base-case scenario in which the economy’s doing fine, a rate cut (or cuts) would be tantamount to spiking the punchbowl, and would therefore extend the sell-by date on our overweight equities and spread product recommendations. We don’t think the U.S. economy needs easier monetary policy, but there’s nothing in the current low-inflation environment that would prevent the Fed from cutting the fed funds rate as insurance against a downturn. Q: But what will happen if the Fed falls short of the rate-cut expectations that are already being discounted by the markets? As implied by the overnight index swap (OIS) curves, the money markets are pricing in 75 basis points (“bps”) of rate cuts in 2019, and another 25 in 2020 (Chart 4). Those expectations are awfully aggressive, and they are flatly incompatible with our constructive view. If the economy proves to be more resilient than expected, spread product will outperform Treasuries, especially given how much the latter have surged on the pickup in risk aversion. In line with our U.S. Bond Strategy service’s Golden Rule of Bond Investing,1 we expect that long-maturity Treasuries will underperform the overall Treasury index if actual rate cuts fall short of expected rate cuts over the next twelve months. We expect that the yield curve will first shift higher as the market discounts a better economic future (real rates rise) and then steepen as investors begin to discount the inflation implications of unneeded incremental monetary accommodation. Chart 4The Money Market Seems To Foresee A Recession Chart 5Stocks Do Better When Real Rates Are Rising If the economy surprises to the upside, the resulting boost to earnings should help equity investors overcome any disappointment resulting from a rate-cut shortfall. In terms of equity analysts’ spreadsheets, we expect that the boost to the earnings numerator would be large enough to overcome the drag from a larger interest rate denominator. Empirically, U.S. equities perform better over periods when real rates are rising than they do when real rates are falling (Chart 5). Q: What do you see for the rest of the world? We see improvement for the rest of the world. After 2017’s globally synchronized upturn, the first since the crisis, 2018 was marked by a sharp divergence in momentum. The U.S., fueled by fiscal stimulus, powered ahead, while China slowed, hobbled by monetary tightening. We think it is telling that the rest of the world followed China, the world’s second largest standalone economy, rather than the U.S., the comparatively closed number one (Chart 6). Chart 6Divergent Paths Our China Investment Strategy and Geopolitical Strategy teams have repeatedly made the case that investors have underestimated the lagged impact of tight monetary policy and slowing domestic credit growth on the Chinese economy over the past two years. While the existing tariffs on imports to the U.S. are a drag on Chinese growth, policymakers’ efforts to redirect credit creation from the shadow banking system to the regulated banking system has had a larger impact on economic activity. Now that the regulatory impediment has been removed, total social financing growth has picked up, and our China team expects it to rise meaningfully over the coming year in order to overcome the combination of still-muted economic momentum and a larger shock to the export sector (Chart 7). The key takeaway is that ongoing policy efforts will allow Chinese growth to stabilize and there is scope for policy to induce re-acceleration over the coming six to twelve months. The bullish scenario holds that Chinese growth will rebound as policymakers make use of that capacity. Chart 7Add Leverage In Case Of Tariffs Chinese imports are the key channel by which China impacts growth in the rest of the world. Increased Chinese aggregate demand will feed increased demand for materials and goods imports. China’s imports are Europe’s, Japan’s, emerging Asia’s, and the resource economies’ exports. If China bottoms and turns higher, we anticipate that its trading partners will as well with a lag of a few months. We side with the bulls and expect that it will, and we expect that the China-driven revival in the global economy, ex-U.S., will help spark a modest self-reinforcing acceleration cycle. As this virtuous circle begins to turn, the growth divergence between the U.S. (where the fiscal thrust from the stimulus package is nearly spent) and the rest of the world will narrow. We expect the dollar will peak once markets catch on to the shift, and that U.S. equities will shift from leader to laggard, in common-currency terms. Narrowing equity outperformance should help push the dollar lower at the margin, which in turn should help blunt Treasuries’ appeal to foreign investors, steering investment capital away from the U.S. Dollar softness, at the margin, should help contribute to S&P 500 earnings gains, reinforcing our bullish equity take in absolute terms. An exogenous shock could trip up the U.S. economy, but it’s hard to find clear-cut signs of internal weakness. Q: What data are you watching to tell you that your view may not come to pass? Much of our sanguine take turns on the idea that monetary policy settings have not yet turned restrictive. We cannot know in real time where the line of demarcation between reflationary and restrictive monetary policy lies, however, so we are on the lookout for data that might disprove our assessment that the fed funds rate is still comfortably in reflationary territory. Housing is the segment of the economy that is most sensitive to interest rates, and we would be concerned if it took a turn for the worse. For now, though, we’re encouraged by the homebuilder sentiment survey, which has retraced nearly all of its fourth-quarter losses (Chart 8), and suggests that the modest recovery in housing starts and new home sales will continue. Chart 8Homebuilders Are Feeling Pretty Chipper Chart 9What Recession? The inverted yield curve has gotten everyone’s attention, but one month of inversion is not enough to declare that a recession is on the way. It also appears that the inversion may have been inspired by investor risk aversion more than a sense that recession is nigh. Our Global Fixed Income Strategy service looked at the average position of several key data series at the onset of the last five recessions and found that conditions look a lot better than they did when those recessions were developing (Chart 9).2 The Leading Economic Index’s (LEI) recession forecasting record matches the yield curve’s. When it contracts on a year-over-year basis, recessions have reliably followed (Chart 10). The LEI is still expanding, but it has been steadily decelerating, and we are keeping a close eye on it. If it contracted while the yield curve was inverted, we would probably have to throw in the towel on our view that policy is still easy, and a recession is therefore still a ways off. Chart 10The LEI Is Not Yet Sounding The Recession Alarm   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Bond Strategy Special Report titled, “The Golden Rule Of Bond Investing,” published July 24, 2018, available at usbs.bcaresearch.com. 2 Please see the Global Fixed Income Strategy Weekly Report titled, “The Risk Aversion Curve Inversion,” published June 4, 2019, available at gfis.bcaresearch.com.

Special Report

Highlights The odds of a cyclical upturn in the global semiconductor sector over the next three to six months are low. Global semiconductor demand will continue to decline due to contracting demand for smartphones, automobiles, personal computers (PCs), and servers. Global semiconductor stocks are still facing considerable downside in absolute terms. We recommend going long Asian semiconductor stocks versus the U.S. S&P 500 semiconductor index. Dedicated EM equity portfolios should stay neutral on the Taiwanese bourse and Korean technology sector relative to the overall EM benchmark. Feature Chart 1 shows share prices of the global semiconductor sector and global semiconductor sales in the past two decades. Chart 1Global Semiconductor Market: Sales & Share Prices Was last December’s trough in global semiconductor equity prices the ultimate bottom in this cycle? The odds are in favor of a continued contraction in global semiconductor sales and further downside in semiconductor share prices over the next three to six months. Cycle-On-Cycle Analysis Semiconductor sales experienced five recessions over the past 20 years. Table 1 illustrates the peak-to-bottom percentage decline in nominal global semiconductor sales and the magnitude of the drop in global semiconductor share prices in U.S. dollar terms during these five cyclical downturns in this industry. It also indicates the duration of each downturn and the number of months that semiconductor stocks led the bottom in global semiconductor sales. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market The current shrinkage of semiconductor sales is worse than the 2011-12 and 2015 downturns. Yet, it is still smaller than the magnitude during the 2008 Great Financial Crisis and the 2001 tech bubble bust. The revenue of semiconductor companies has so far contracted by 24%, which is disproportionally more than the decline in share prices of these companies. The global semiconductor equity index is only 14% below its March 2018 high. It appears as though the market is expecting a quick recovery in semiconductor sales. As per Table 1, in the downturns of 2008, 2011 and 2015, global semiconductor stocks all bottomed before the bottom of global semiconductor sales. Only in the 2001 episode, stock prices bottomed eight months after the bottom in sales. In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction,1 far less than the 13-16 months experienced in all the past four cycles. All in all, we would lean against the market’s expectation of an imminent recovery in the semiconductor cycle. The demand downturn will last another three to six months and share prices are facing major headwinds. Global Semiconductor Demand Semiconductor sales are in contraction across countries and regions (Chart 2). In April – before President Trump’s tweet on imposing new import tariff on China, global semiconductor sales growth sank to a negative 15% year-on-year. The short-term (three-to-six month) outlook for global semiconductor demand remains dismal. Chart 3 shows global semiconductor revenue breakdown in terms of end usage. Mobile phones account for the largest share (29%) of the market, followed by PCs (12%), miscellaneous consumer products (12%), and servers (11%). All of these major demand sources are under downward pressure: Smartphone Sales Global smartphone sales are shrinking (Chart 4). According to the International Data Corporation (IDC), global smartphone shipments declined 6.6% year-on-year in volume terms in the first quarter of this year, worse than last year’s 4.4% drop. Chart 2Semiconductor Sales Are In Contraction Across Countries  In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction, far less than the 13-16 months experienced in all the past four cycles. Chart 4Global Smartphone Sales: Contracting We expect smartphone shipments to continue contracting in the second half of this year. Major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. For example, U.S. shipments were down 15% year-on-year in the first quarter due to near-full market penetration. In China, smartphone sales have shown signs of stabilization (Chart 5). However, this is probably temporary and has been driven by the boom in Huawei smartphone sales in China since early this year. The incredible 50% year-on-year growth of Huawei smartphone sales in the first quarter is not sustainable. While global sales of Huawei smartphones increased by 20 million units, total global smartphone sales of all brands fell by 22 million units (Chart 6). The U.S. punitive actions towards China and Huawei have also instigated nationalism in China. This has triggered a Chinese buying-spree of the Huawei smartphone. Chart 5Chinese Smartphone Sales: Temporary Stabilization Yet, this has probably reduced the number of potential Chinese smartphones buyers in the near future. After all, many buyers likely made the purchase earlier than otherwise planned in the absence of a trade war. Although Samsung, Huawei, OnePlus, Xiaomi, Motorola, LG, and ZTE have either released or will release their 5G phones this year, the sales growth from 5G phones will not be able to offset the loss in 2G, 3G and 4G phone sales, at least not in 2019. The IDC estimated that 5G phones would only account for about 0.5% of the market share this year. 5G will likely only begin affecting overall semiconductor demand next year, when they account for a larger share of smartphone sales.   Huawei is the market leader in 5G technology. The U.S. boycott of Huawei will likely continue. This will only slow the pace of 5G phone adoption and the development of 5G networks worldwide. On balance, global smartphone demand may only recover next year. Server Demand Global server shipments also experienced a 5% contraction in volume terms in the first quarter of this year, according to IDC (Chart 7). The outlook for the rest of 2019 does not look promising. Global server demand will likely remain in contraction in the second half of this year. Many hyperscale data centers have already purchased considerable amounts of severs in advance of the trade war to avoid tariffs.2 Meanwhile, the escalation in the U.S.-China confrontation has increased economic uncertainties. This may delay potential datacenter investments. Decelerating 5G network development worldwide due to the U.S. ban on Huawei will also tend to discourage new datacenter and cloud services projects. This is because the 5G technology enables datacenter and cloud services to experience a huge improvement in terms of data transfer speeds, latency, connectivity, capacity, reliability and mobility. Chart 7Global Server Shipment: Are In Contraction Personal Computers (PC) PCs sales are also in contraction (Chart 8). PC demand has entered into the deep-maturation phase while facing strong competition from tablets and laptops. Auto Sales Global auto sales also sank by 5% in April from a year ago, registering the worst contraction since 2009 (Chart 9). Chart 8Global PCs Sales: Deeply Saturated Chart 9Global Auto Sales Are In Contraction As Well Regarding auto demand, the Chinese government may continue to implement more supportive policies to stimulate car sales in China. However, we believe the recovery will be delayed. The government has already implemented a number of policies to lift domestic car sales since late January, including providing subsidies to encourage new energy vehicle sales, to promote auto sales in rural areas, and to increase auto replacement. The central government recently loosened auto sales restrictions in the first tier cities of Guangzhou and Shenzhen that have restrictive auto sales policies. However, all of these policies have failed to lift Chinese domestic car sales out of deep contraction. The key reason has been a diminishing willingness to spend among Chinese consumers, as suggested by falling households’ marginal propensity to consume (Chart 10). Bottom Line: Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. Chart 10Chinese Consumers: Diminishing Willingness To Consume Inventories And Prices Chart 11 shows the semiconductor supply chain illustrating the process of manufacturing semiconductors starting with silicon wafers and up to final electronic products. Box 1 explains the role of key segments and players along the supply chain. Box 1 A Brief Explanation Of The Key Segments/Players Of The Supply Chain Both integrated device manufacturers (IDM) and foundries are at the center of the supply chain, responsible for chip manufacturing. In terms of semiconductor sales revenue, Samsung, Intel and SK Hynix are the world’s top three IDM companies and TSMC, Global Foundries and United Microelectronics Corp (UMC) are the world’s top three foundries. While IDMs cover most of the process from IC design, chip fabrication, assembly, testing and packaging, IDM companies still have to purchase raw materials and equipment for the chip-making process. Foundry companies receive orders from IC designing companies like Qualcomm, Nvidia, and Huawei HiSilicon, then purchase needed raw materials and equipment to proceed in the chip-manufacturing process. Both IDMs and foundries can either outsource the tasks of semiconductor assembly and testing or perform them on their own. The final semiconductor products will be used in electronics products, such as smartphones, computers, home appliances, automobiles, etc. Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. In a typical business cycle, a cyclical downturn begins with a slump in demand for final electronic products (upstream demand). This leads to falling semiconductor sales. As a result, inventory buildup will occur across most of the segments along the semiconductor supply chain. Chipmakers: Producers’ semiconductor inventory in both Taiwan and Korea have reached either a record high or a near-record high (Chart 12). The installed wafer capacities at these two countries are the world’s largest, together accounting for 43% of total global wafer capacity. In addition, the inventory of some major electronic parts and components have also increased considerably in Taiwan (Chart 13). This also implies weaker demand for semiconductor raw materials. Chart 12Chipmakers: A Rapid Buildup In Inventory Chart 13Rising Inventory Of Some Major Electronic Parts And Components Raw material suppliers: Silicon wafer is the indispensable raw material required in the chip manufacturing process. Japanese companies account for over half of global silicon wafer supply.Chart 14 shows that silicon wafer inventory in Japan has had a significant buildup in volume terms since late last year. Importantly, it is not declining yet. Chart 14Silicon Wafer Inventory: A Significant Buildup As Well Outsourced semiconductor assembly and test (OSAT) providers: Both Singapore and Thailand are OSAT providers while they also manufacture, assemble and export electronic products. Both countries are closer to the downstream side of the semiconductor supply chain. Semiconductor inventory at these two countries has also jumped to a record high (Chart 15).   Chart 15Singapore and Thailand: Record High Semiconductor inventory   Importantly, a marginal improvement in demand will tend to support spot prices. For example, in the memory chip market, falling prices denote weak demand relative to excess supply. When prices of DRAM and NAND start to form a bottom or decisively move up, this may indicate the arrival of a cyclical upturn. So far, both DRAM and NAND prices are continuing to fall (Chart 16). In addition, the prices of silicon wafer – the most important raw material used in the chip-making process – have declined in the first half of this year.3  Chart 16Still Falling Memory Chip Prices Chart 17Deflating DRAM Prices Suggest Downside Risks To Korean Tech StocksIn short, prices are the most important variable to monitor. Chart 17 exhibits the high correlation between DRAM prices and the Korean technology sector stock prices. Falling DRAM prices suggest downside risks to technology stocks in Korea. Samsung accounts for about 65% of Korea’s tech index and 27% of the overall Korean equity index. Memory chips accounted for 68% of Samsung’s operating profits in the first quarter of this year.   Bottom Line: There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow a downbeat near-term outlook. The Interpretation Of Some Positive Developments There have been some positive developments in the past several months. Taiwanese PMI new orders diffusion index in the electronics sector jumped out of deep contraction to reach zero, and Chinese semiconductor imports halted their decline in both volume and value terms (Chart 18). The improvement in the aforementioned data was probably mainly due to large semiconductor purchases by China to hedge the rising risk of U.S. blocking China’s technological development (Chart 19). Chart 18Some Positive Development Chart 19China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? Besides, Huawei smartphone sales have been booming, which we deliberated on page 5, could have been responsible for the improvement in these data. This one-off surge will likely dwindle going forward. Investment Conclusions We remain negative on Asian semiconductor share prices in absolute terms. A continued contraction in global semiconductor sales will further squeeze their profits. In relative terms, we are neutral on the Asian semiconductor sector: we continue recommending market-weight allocation to Taiwan’s overall market and the Korean technology sector within the EM equity benchmark. As a new trade, we recommend going long Asian semiconductor stocks and short the S&P 500 semiconductor index over the next three to six months (Chart 20). The Bloomberg Asia Pacific semiconductor index has nine stocks. Samsung and TSMC account for 42% and 38% of the index, respectively. There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow the downbeat near-term outlook. Samsung will likely benefit from the U.S. ban on Huawei in the smartphone sector outside of China. In addition, Samsung will win some market share from Apple as the latter does not have a 5G phone to release this year. These positive factors may partially offset the negative impact from falling memory prices and demand on Samsung. The S&P 500 semiconductor index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 70% of the index. Most of these companies are IC designing companies, which will likely suffer as Chinese demand for their products shrink due to the U.S. administration's ban on Huawei. This position will also benefit from U.S. dollar appreciation. A firm dollar will hurt profits of U.S. semiconductor stocks. In turn, currency depreciation in Korea and Taiwan will on the margin benefit Asian semiconductor stocks. Chart 20Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Chart 21The 2015 Experience Chart 21 shows that global foundry companies outperformed global IC designing companies during the final phase of the 2015 cyclical downturn. Odds are that these dynamics will play out in this downturn as well. Finally, the relative performance of Asian semiconductor stocks versus U.S. ones is oversold and might stage some sort of mean reversion (Chart 20). Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Please note that here the calculation for “the number of months of the growth contraction” is different from the one for the “peak-to-bottom duration” in Table 1. “The number of months of the growth contraction” equals the number of months when semiconductor sales year-on-year growth is negative. 2      https://marketrealist.com/2019/05/nvidias-data-center-revenue-inference-rendering-and-edge/ 3      http://www.sohu.com/a/300386061_132567, http://news.moore.ren/industry/104958.htm   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The European barometer that best gauges global growth is euro area growth excluding inventory adjustments. Euro area growth excluding inventory adjustments is now running at a blistering 4.2 percent nominal pace – close to its 10-year upper bound – and is unlikely to accelerate much further. All the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer will show weaker readings in the second half of the year. We present the correct investment strategy for this environment within the report. Feature Chart of the WeekGrowth Isn’t Going To Get Much Better Europe is an excellent barometer of the world economy. Not only is Europe a big chunk of the global economy in its own right, Europe also has a very open economy with a huge external sector. Gross exports amount to almost a half of GDP in the euro area, compared to little more than a tenth in the United States (Chart I-2). But here’s the key point: the European barometer that best gauges global growth is not euro area growth per se; it is euro area growth excluding inventory adjustments (Chart of the Week and Chart I-3). Chart I-2Europe Has A Very Open Economy Chart I-3Euro Area Growth Ex Inventory Adjustments Has Rebounded Sharply If euro area firms were building inventories, it would clearly boost economic output; and vice versa. However, this inventory building would not represent genuine end demand from abroad. It follows that we must strip out inventory adjustments to yield a truer gauge of external demand.1 The Reading From Our European Barometer What does euro area growth excluding inventory adjustments show? The long-term analysis confirms that global activity suffered its sharpest setbacks this millennium in 2002, 2008, 2012, and again briefly last year. But in the first quarter of this year, euro area real growth excluding inventory adjustments bounced back to a very robust 2.5 percent clip or, in nominal terms, a blistering 4.2 percent clip.2 Indeed, in nominal terms, our barometer was close to its strongest reading since 2010! These impressive numbers leave us with not a shred of doubt: after a sharp setback, global growth commenced a strong rebound at the end of last year. Global growth commenced a strong rebound at the end of last year. For those still in doubt, further compelling evidence comes from the very clear recent outperformance of the economically sensitive global sectors: industrials and financials. Through the past decade, the relative performance of these global cyclicals has closely tracked our European barometer – albeit a brief decoupling did occur in 2012 after Draghi’s “whatever it takes” speech gave all financial assets a big shot in the arm (Chart I-4). Chart I-4Global Cyclicals Are Tracking Our Growth Barometer One problem is that our barometer gives a reading just once a quarter and these readings come out after a long delay. From the mid-point of the quarter to which the GDP data refers to their release date around one month after the quarter end, there is a two and a half month delay. Begging the question, is there a more frequent and timely current activity indicator (CAI) for the euro area? The answer is yes. We have found that the ZEW economic sentiment indicator (not to be confused with the current situation indicator) does the job well in real-time (Chart I-5 and Chart I-6). Chart I-5The ZEW Economic Sentiment Indicator... Chart I-6...Is A Good Current Activity Indicator   How Should Investors Use Our Barometer? However, investors face an even more fundamental problem. The equity market is itself a real-time current activity indicator. To be more precise, the best current activity is not the equity market taken as a whole – because the aggregate equity market can move as a result of drivers other than current economic activity, most notably central bank policy. Rather, as we have just shown, the very best current activity indicator is the performance of economically sensitive sectors – such as industrials and financials – relative to the total market (Chart I-7 and Chart I-8). Chart I-7The Best Current Activity Indicator... Chart I-8...Is The Relative Performance Of Global Cyclicals This means that even if we could measure GDP growth excluding inventory adjustments in real time, it would not help investors. After all, it would be ludicrous to expect one current activity indicator consistently to lead another current activity indicator! What we really need is a future activity indicator (FAI). If we could reliably predict where our barometer’s reading would be three or six months from now we could also reliably allocate our investments ‘ahead of the move’. Still, sometimes the current reading does inform us about the future. If a barometer already reads ‘very dry’ then we know that the weather is not going to get any better in the next few months! To be clear, euro area nominal growth excluding inventories, running at a blistering 4.2 percent pace, is near a 10-year high not just on a quarter-on-quarter basis but also on a six month on six month basis. The chances that it moves significantly higher are close to nil.   We are at the tail-end of a global growth up-oscillation. We should also look at the short-term impulses that drive growth. Crucially, these emanate from the short-term changes – and not the levels – of bond yields, the oil price (inverted), and bank credit flows. These impulses are now losing momentum (Chart I-9). Chart I-9Short-Term Impulses Are Losing Momentum The Correct Investment Strategy   To sum up, all the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer – euro area growth excluding inventory adjustments – is highly unlikely to accelerate much further from its blistering 4.2 percent nominal clip. Much more likely, it will show weaker readings in the second half of the year. The yen is still an excellent defensive currency. Nevertheless, in the near term, asset allocation is a tough call. This is because, very unusually, all asset classes have performed well in unison, making it hard to rotate into one that offers value (Chart I-10). Hence, from a tactical perspective, we are shorting a 30:60:10 portfolio of equities, long-dated bonds, and crude oil. So far, the position is slightly down but we recommend holding it until it either achieves a 3 percent profit or it hits a 3 percent stop-loss. Chart I-10All Asset-Classes Have Performed Well In Unison For equities versus bonds, our long DAX versus the 30-year bund is now broadly flat since inception in January. But we will hold it for a while longer until we see clearer signs that global growth has flipped into a down-oscillation.   Within bonds, our underweight German 10-year bunds versus U.S 10-year T-bonds is still appropriate given the closer proximity of the bund yield, at -0.2 percent, to the mathematical lower bound. Moreover, this relative position has been working well recently.  Within equities, overweight European equities versus China and the U.S. has also been working well. However, we will be looking for opportunities to switch to underweight Europe versus the less economically sensitive U.S. equity market within the next couple of months. Finally, our stance to the euro – long versus the dollar, short versus the yen – has also been working well. The stance remains appropriate as the yen is still an excellent defensive currency, with the big additional advantage of possessing minimal political risk. Fractal Trading System* Given the synchronized rally of all asset classes this year, the financial services sector has strongly outperformed the market. But according to its 130-day fractal dimension, this strong outperformance is approaching technical exhaustion. Accordingly, this week’s trade recommendation is to short the financial services sector versus the market. The profit target is 2 percent with a symmetrical stop-loss. (One way of executing this is to short the IYG ETF versus the MSCI All Country World Index). In other trades, we are pleased to report that short NZX 50 versus FTSE100 achieved its 2 percent profit target and is now closed, leaving three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 To be precise, it is the change in the change in inventories that contributes to GDP growth. For example, if the change in inventories added 0.5 percent to GDP this quarter, but 1 percent last quarter, then it will have subtracted 0.5% from growth this quarter. 2 Quarter-on-quarter growth at annualised rates. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Feature Through the past five years, the global long bond yield has tried to surpass 2.5 percent on three occasions – once in 2015, twice in 2018. But it has failed (Feature Chart). The global long bond yield’s five-year struggle to break through 2.5 percent convinces us that the so-called ‘neutral’ rate of interest is now extremely low, indeed zero in real terms. This is a very high conviction view though, to be clear, not every BCA strategist may necessarily concur. Feature ChartSince 2015, The Global Long Bond Yield Has Struggled To Surpass 2.5 Percent The neutral rate of interest is the interest rate at which monetary policy is neither accommodative nor restrictive, the interest rate consistent with the economy maintaining full employment while keeping inflation constant. That much is generally accepted. Here’s where we differ from the conventional thinking: what is setting the neutral rate now is not the economy’s direct sensitivity to the interest rate via rate sensitive sectors such as mortgage lending or home construction: rather, it is the economy’s indirect sensitivity to the interest rate via its impact on equities and other so-called ‘risky’ assets. This Special Report challenges the conventional wisdom on the neutral rate on three specific points: The neutral rate is based on the bond yield, not on the policy interest rate. The neutral rate is global, not European or region specific. The neutral rate is nominal, not real. The Neutral Rate Is Based On The Bond Yield, Not On The Policy Interest Rate The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. These risky assets are long-duration assets, because their cash flows extend into the distant future. Hence, the market calibrates the expected return available on these risky assets from the supposedly less risky return available from long-duration bonds – the bond yield – plus a ‘risk premium’. Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent advances outside their field of expertise. Years of research in behavioural finance conclude that the measure that best encapsulates our perception of an investment’s risk is not its volatility but its negative asymmetry: the potential largest loss as a multiple of the potential largest gain (Chart I-2). The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. Crucially, when the bond yield gets low, the proximity of its lower bound dramatically reduces the potential for price gains while leaving open the potential for large losses. This sudden onset of negative asymmetry means that bonds are no longer less risky than equities or other risky assets (Chart I-3). So risky assets no longer need to deliver a higher expected return than bonds (Chart I-4). Chart I-5Equities Offer Diversification Benefits Too! Some people counter that bonds offer investors a diversification benefit and, because of this, investors still need a higher return from equities. This argument is wrong. Just as bonds can protect equity investors, equities can protect bond investors during vicious sell-offs in the bond market – such as after Trump’s shock victory in 2016 (Chart I-5). So we could equally argue that equities require the lower return. In fact, at a low bond yield, with the same negative asymmetry and diversification properties, both equities and bonds must offer the same prospective return.   The upshot is that once the bond yield gets low and stays low, equity (and other risky asset) returns collapse to the feeble return offered by bonds with no additional ‘risk premium’ giving the valuation of $400 trillion of assets an exponential uplift (Chart I-6). The unfortunate corollary is that if the bond yield was no longer low, the valuation of $400 trillion of assets would suffer an exponential decline. And the consequent deterioration in financial conditions would send a chill wind through the global economy. Theoretically and empirically, the hyper-sensitivity of equity valuations to bond yields is greatest when the 10-year bond yield is in the 2-3 percent range. But which 10-year bond yield?1  Chart I-6Equities Are Now Priced To Generate A Feeble Long-Term Return The Neutral Rate Is Global, Not European Or Region Specific The question: ‘will European equities go up or down?’ is essentially the same as ‘will U.S. equities go up or down?’ or ‘will Chinese equities go up or down?’ albeit the size of the moves can be quite different. The same applies to mainstream bond markets; in directional terms, bonds move together. Chart I-7The Global 10-Year Yield Is The Average Of The Euro Area, U.S., And China Given this tight directional integration of global capital markets – and to some extent economies too – asset allocators make the asset class choice between equities and bonds their primary decision, and the regional allocation the subsidiary decision. It follows that the point of hyper-sensitivity of equity valuations, be it in Europe or any other region, is when the global 10-year bond yield is in the 2-3 percent range. What is the global 10-year bond yield? Previously, we defined it in terms of the German bund, U.S. T-bond, and JGB. But we now have an even better definition: it is the simple average of the 10-year yields in the world’s three major economies; the euro area, U.S., and China (Chart I-7).2  Given this yield’s five year struggle to surpass 2.5 percent, we can say that the ‘neutral’ rate, at which tighter financial conditions do not threaten any major economy, might be somewhere below this recent empirical limit, at around 2 percent. The Neutral Rate Is Nominal, Not Real Investors always think about the negative asymmetry of returns in nominal terms. This is because the losses they fear tend to be too short and too sharp for the real return to be meaningfully different from the nominal return.3 It follows that the aforementioned hyper-sensitivity of equity valuations is when the nominal bond yield is in the 2-3 percent range, resulting in a neutral nominal rate which might be 2 percent (Chart I-8). But if inflation is also running fairly close to 2 percent, as it is in the major economies, the upshot is that the neutral real rate of interest is zero.  What Does All Of This Mean? To sum up, a decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields (Chart I-9). But the dependency is not of the rate sensitive sectors in the economy per se, rather it is of the rich valuation of risky assets whose worth dwarfs the global economy by five to one (Chart I-10). Gradually, this dependency should diminish as economic and profit growth improves valuations, but this will take time. Chart I-9A Decade Of Ultra-Loose Monetary Policy... Chart I-10...Has Made The Rich Valuation Of Risky Assets Dependent On Low Bond Yields In the meantime, the integration of global capital markets means that the valuation cue for European – and all regional – stock markets now comes from the global 10-year bond yield. Given its recent decline to slightly below neutral, stock markets are unlikely to free fall. A decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields. That said, the aggregate market is likely to be in a sideways structural pattern, as it has been for the past eighteen months, and the big opportunities will continue to come from sector rotation: in the second half of the year switch out of economically sensitives such as industrials, and into defensives such as healthcare. A final point is that any decline in the global bond yield to below neutral will come disproportionately from higher yielding bond markets. This will underpin the lower yielding major currencies such as the euro. But our first choice for the second half of the year remains the Japanese yen. Fractal Trading System* This week, we see an excellent opportunity to short Russia’s recent strong outperformance versus Japan. The recommended trade is short MOEX versus Nikkei225 with a profit target of 5 percent and symmetrical stop-loss. In other trades, short WTI crude versus LMEX achieved its profit target. Against this, short the French OAT reached its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative asymmetry than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative asymmetry. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 We define the global 10-year bond yield as the simple average of the three 10-year bond yields in the euro area, U.S., and China, where the 10-year bond yield in the euro area is the issue-weighted average of the euro area’s individual 10-year bond yields. 3 For example, if bonds had a countertrend correction of 10% in a month when the economy was suffering severe deflation of 10% (per annum), it would still equate to a 9% loss in real terms! Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - ##br##Interest Rate Expectations Chart II-6Indicators To Watch -##br## Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch - ##br##Interest Rate Expectations  

Feature The GAA DM Equity Country Allocation model is updated as of May 31, 2019.  The quant model has not made significant changes in the major country allocations, but has further increased Australia’s overweight after the upgrade in the previous month, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1,  2 and  3, the overall model outperformed the MSCI World benchmark by 17 bps in May, largely from a 17 bps of outperformance from the Level 1 model, as the Level 2 model only eked out 1 bp of outperformance.  Directionally, five out of the 12 choices generated positive alpha. The largest contributions to the outperformance in May came from the overweight in Switzerland and Australia, as well as the underweight in the U.S.  Since going live, the overall model has outperformed by 170 bps, with a 350 bps of outperformance by Level 2 model, and an 11bps of outperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of May 31, 2019. Chart 4Overall Model Performance Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations       The model’s relative tilts between cyclicals and defensives have changed compared to last month. On the backdrop of weaker global growth, the model has become positive on Consumer Staples and upgraded the sector. This was driven by both the momentum and growth components. This in turn decreases the overweight allocations to Industrials and Utilities, the model’s two overweights, and increases the underweight allocation to the eight remaining sectors. The valuation component remains muted across all sectors. Our expectations are that global growth bottoms in the back end of the year. However, the hard data has not fully materialized yet. While escalated trade war tensions between the U.S. and China continue to put downward pressure on growth indicators, Chinese credit and fiscal stimulus, similar to that of 2009 and 2015, will more than likely put a floor under further downside. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Highlights Monetary policy remains accommodative in Japan, but will tighten on a relative basis if the Bank Of Japan (BoJ) stands pat. The BoJ’s margin of error is non-trivial, since a small external shock could well tip the economy back into deflation. Historically, the BoJ has needed an external shock to act, suggesting the path towards additional stimulus could be lined with a stronger yen. Our bias is that USD/JPY could weaken to 104 in the next three to six months, especially if market volatility spikes further. We are carefully monitoring any shift in the yen’s behavior, in particular its role as a counter-cyclical currency. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. Feature The powerful bounce in global markets since the December lows is sitting at a critical juncture. With the S&P 500 at its 200-day moving average, crude oil and Treasury yields plunging and the dollar taking a bid, it may only require a small shift in market prices to change sentiment sharply. The yen has strengthened in sympathy with these moves, but the balance of evidence suggests the possibility of a much bigger adjustment. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. BoJ: Out Of Policy Bullets For most of the 1990s, Japan was in a deflationary bust. In hindsight, the reason was simple: The structural growth rate of the economy was well below interest rates, which meant paying down debt was preferable to investing. Tight money also led to a structurally strong currency, reinforcing the negative feedback loop (Chart I-1). Chart I-1The Story Of Japan In One Chart Much farther down the road, the three arrows of ‘Abenomics’ arrived, ushering in a paradigm shift. Since 2012, Japan has enjoyed one of its longest economic expansions in recent history, having fine-tuned monetary policy each time private sector GDP growth has fallen close to interest rates. The result has been remarkable. The unemployment rate is close to a 26-year low, and the Nikkei index has tripled. But if the economy once again flirts with deflation, additional monetary policy options may be hard to come by, since there have been diminishing economic returns to additional stimulus. Chart I-2Stealth Tapering By ##br##The BoJ Chart I-32 Percent Inflation Equal Mission Impossible? The end of the Heisei era1 has brought forward the urgency of the above quandary. At its latest monetary policy meeting, the BoJ strengthened forward guidance, expanded collateral requirements for the provision of credit, and stated that it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”2 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs, and almost 5% of JREITs, this will be a tall order. The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and is unlikely to change anytime soon. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at its current pace, then the rate of expansion in its balance sheet will severely slow, and could trigger a knee-jerk rally in the yen (Chart I-2). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. It pays attention to three main variables when looking at inflation: Core CPI, the GDP deflator, and the output gap. All indicators are pointing in the right direction, but the recent slowdown in the global economy could reverse this trend. It is always important to remember that the overarching theme for prices in Japan is a falling (and aging) population leading to deficient demand (Chart I-3). More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an aging demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years the government has been a thorn in the side of telecom companies, pushing them to keep cutting prices, given domestic pressures from its voting base. Transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI (Chart I-4), making it difficult for the BoJ to re-anchor inflation expectations upward. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathemas for Japanese net interest margins and share prices (Chart I-5). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. Chart I-4The Japanese Prefer Falling Prices Chart I-5Negative Rates Are Anathema To Banks Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it might first require a riot point. Go short USD/JPY. High Hurdle For Delaying Consumption Tax Since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a disastrous outcome. More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Foreign and domestic machinery orders are slowing, employment growth has halved from 2% to 1%, and wages are inflecting lower (Chart I-6). This is especially worrisome since the labor market has been the poster child of the Japanese recovery.3 The consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Why go ahead with the consumption tax then? The answer lies in the concept of Ricardian equivalence.4 Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has remained tepid. By the same token, the savings ratio for workers has surged (Chart I-7). If consumers are caught in a Ricardian equivalence negative feedback loop, exiting deflation becomes a pipe dream. Chart I-6A Bad Omen Increased social security spending: This will be particularly geared towards child education. For example, preschool and tertiary education will be made free of charge. Promoting cashless transactions: Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. This incentive should help lift the velocity of money. Chart I-7Strong Labor Market, Weak Consumption Construction spending: This will offset the natural disasters that afflicted Japan last year. Construction orders in Japan accelerated at a 66% pace in March. The Abe government’s strategy has so far been to offset the consumption tax hike with increased domestic spending. The thinking is that once in a liquidity trap, the fiscal multiplier tends to be much larger. Some of these outlays include: Chart I-8Japan Needs More Fiscal Stimulus The new immigration law will also help. Foreign workers were responsible for 30% of all new jobs filled in Japan in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will be beneficial for consumption. To be sure, this may not be enough. The IMF still projects the fiscal drag in Japan to be 0.1% of GDP in 2019 and 0.6% in 2020 (Chart I-8). This puts the onus back on the BoJ to ease financial conditions. A combination of easier fiscal and monetary policy will be a headwind for the yen. This could happen if the U.S./China trade war escalates, and twists the arm of the finance ministry. But the hurdle is high for the government to roll back the consumption tax, given significant spending offsets. The Yen As A Safe Haven Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence (Chart I-9). This is because with a net international investment position of almost 60% of GDP and net income receipts of almost 4% of GDP, volatility in markets tend to lead to powerful repatriation flows back to Japan. Real interest rates also tend to be higher in Japan in recessions as already-low inflation expectations fall further. Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence. Some have suggested that the BoJ’s asset purchases are pushing investors out of Japan and weakening the safe-haven status of the yen. While plausible, our view is that other factors have been at play. First, tax changes led to repatriation of capital back to the U.S. in 2018. This unduly pressured foreign direct investment in Japan as well as other safe-haven countries like Switzerland. Second, Japan, by virtue of its current account surplus, runs a capital account deficit. This means that portfolio outflows are the norm. This is how it has managed to build the biggest net international investment position in the world. Only in times of severe flight to safety are those investments liquidated and brought home. More importantly, the time may now be very ripe for yen long positions, given rising suspicion towards the currency as a haven. To see why, one only has to return to late 2016. Back then, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the BoJ. Despite that backdrop, the yen strengthened by almost 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. With U.S. interest rates having risen significantly versus almost all G10 countries in recent years, including Japan’s, the dollar has become a carry currency. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and these trades get unwound, this will be a powerful undercurrent for the yen (Chart I-10). Chart I-9The Yen Remains A Safe Haven Chart I-10The Yen Has Financed Carry Trades Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. What If Global Growth Picks Up? The eventual bottom in global growth is a key risk to our scenario. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds, but it will be important to monitor if this correlation shifts during the next equity market rally. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Our contention is that the yen will surely weaken at the crosses, but could strengthen versus the dollar. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Meanwhile, large net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-12). Chart I-11Japan: Better Governance, Higher ROIC Chart I-12Short USD/JPY: A Contrarian Bet Bottom Line: Short USD/JPY trades have entered into an envious “heads I win, tails I do not lose too much” position. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up later this year, the yen could weaken on its crosses but may actually strengthen versus the dollar. Housekeeping We are closing our short EUR/CZK position with a 4.7% profit. Interest rate differentials between the Czech Republic and the euro area have widened significantly, at a time when growth and labor market tightness could be fraying at the edges. Meanwhile, possible weakness in the dollar will be a risk to this position.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period corresponding to the reign of Japanese Emperor Akihito from 1989 until 2019. 2 Please see “Minutes of the Monetary Policy Meeting,” Bank of Japan, dated May 8, 2019, p.27. 3 Sample changes last year make it more difficult to have an apples-to-apples comparison for wages. 4 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data in the U.S. have been negative: Total durable goods orders decreased by 2.1% in April. On the housing front, FHFA house price growth fell to 0.1% month-on-month in March. MBA Mortgage applications fell by 3.3% in May. Conference Board consumer confidence index improved to 134.1 in May. Dallas Fed Manufacturing activity index fell to -5.3 in May. Annualized GDP came in at 3.1% quarter-on-quarter in Q1, revised from the previous 3.2% but higher than the consensus of 3%. Q1 headline and core PCE both fell to 0.4% and 1% quarter-on-quarter respectively. DXY index increased by 0.6% this week. In the long-term, we maintain a pro-cyclical stance, and continue to believe that the path of least resistance for the dollar in down. In the short-term however, there is more room for the trade-weighted dollar to rise before eventually reversing, amid global data weakness and political uncertainties. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro EUR Technicals 1 EUR Technicals 2 Recent data in the euro area have shown improvement: Private loans increased by 3.4% year-on-year in April. Money supply (M3) increased by 4.7% year-on-year in April. Business climate indicator fell to 0.3 in May. Despite the weak business climate indicator, soft data in the euro area have generally improved in May: economic confidence rose to 104; industrial confidence increased to -2.9; services confidence climbed to 12.2. Lastly, the consumer confidence increased to -6.5. EUR/USD fell by 0.7% this week. During this weekend’s European Parliament election, the European People’s Party (EPP) won with 24% of the seats. However, 43 seats were lost compared with their last election result. The S&D party also lost 34 seats, together ending the 40-year majority of the center-right and center-left coalitions. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen JPY Technicals 1 JPY Technicals 2 Recent data in Japan have been negative: All industry activity index fell by 0.4% month-on-month in March. The leading index and coincident index both fell to 95.9 and 99.4 respectively in March. PPI services fell to 0.9% year-on-year in April, below the expected 1.1%. Labor market  and CPI data will be released after we go to press today. USD/JPY rose by 0.3% this week. BoJ Governor Haruhiko Kuroda has given two speeches this week, warning about the high degree of uncertainty, and potential downside risks worldwide. On the positive side, Kuroda thinks that EM capital outflows are less at risk than during recent financial crises, given a better framework for risk management. In the meantime, uncertainties remain regarding the U.S.-Japan trade disputes, especially vis-à-vis Japanese auto exports. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound GBP Technicals 1 GBP Technicals 2 Recent data in the U.K. continue to outperform: Total retail sales increased by 5.2% year-on-year in April, surprising to the upside. BBA mortgage a pprovals increased to 43 thousand in April. GBP/USD fell by 0.8% this week. The uncertainties of Brexit increased with the resignation of Prime Minister Theresa May last Friday. With a Brexit decision not due until October 31, 2019, the U.K. has participated in the recent EU election. The newly formed Brexit Party led by Nigel Farage, won with more than 31% of the votes. This reflects a growing dissatisfaction with traditional parties within U.K. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar AUD Technicals 1 AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 118.6 this week. HIA new home sales fell by 11.8% month-on-month in April. Moreover, building permits decreased by 24.2% year-on-year. Private capital expenditure in Q1 fell by 1.7% quarter-on-quarter. Building approvals fell by 4.7% month-on-month in April. AUD/USD fell by 0.2% this week. As we argued in last week’s report, we favor the Aussie dollar from a contrarian point of view. Despite the negative data points on the surface, the recent election result and dovish shift by RBA all support the Australian economy in the long-term. Moreover, the robust job market, rising terms of trade, and Chinese stimulus will likely put a floor under AUD/USD. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ activity outlook increased by 8.5% in May, well above consensus. Building permits fell by 7.9% month-on-month in April. ANZ business confidence remained low at -32 in May. NZD/USD fell by 0.6% this week. The Financial Stability Report, released by RBNZ this week, highlighted the worrisome debt levels, particularly in the household and dairy sectors. Ongoing efforts are necessary to bolster system soundness and efficiency, according to RBNZ governor Adrian Orr. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Recent data in Canada have been positive: Bloomberg Nanos confidence index improved to 55.7, from the previous 55.1. Current account deficit increased to C$17.35 billion from C$16.62 billion, but it is lower than the expected C$ 18 billion. USD/CAD increased by 0.4% this week. On Wednesday, the Bank of Canada (BoC) held interest rates steady at 1.75%, as widely expected. Despite the recent trade uncertainties, the BoC views the slowdown in late 2018 and early 2019 as temporary, and expects growth to pick up again in the second quarter this year, supported by recovering oil prices, stabilizing housing sector, robust job market and easy financial conditions. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data in Switzerland have been mixed: Q1 GDP came in higher-than-expected at 1.7% year-on-year, from the previous reading of 1.5%. Trade surplus reduced to 2.3 million CHF in April, mostly due to the decrease in exports. KOF leading indicator fell to 94.4 in May. ZEW expectations fell in May to -14.3. USD/CHF appreciated by 0.7% this week. We favor the Swiss franc as a safe haven when market volatility rises. In the longer term, the high domestic savings rate, rising productivity, and current account surplus should all underpin the franc. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone NOK Technicals 1 NOK Technicals 2 There is little data from Norway this week: Retail sales increased by 1.6% year-on-year in April. Credit expanded by 5.7% year-on-year in April USD/NOK increased by 0.9% this week. Our Commodity & Energy Strategy team believe that the energy market is underpricing the U.S. - Iran war risk, and overestimating the short-term effects of the trade war. In the long run, the Chinese stimulus, dollar weakness, and supply uncertainties should lift oil prices, which will support the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data in Sweden have been mostly negative: Producer price inflation fell to 4.9% year-on-year in April from 6.3% in March. Consumer confidence fell to 91 in May. Moreover, manufacturing confidence fell to 103.7 in May. Trade surplus fell from 6.4 billion to 1.4 billion SEK in April. Q1 GDP came in at 2.1% year-on-year, outperforming expectations but lower than the previous 2.4%. USD/SEK has been flat this week. Swedish exports, a reliable barometer for global business confidence, fell from 133.4 billion SEK to 128 billion SEK in April, which is a total decrease of 5.4 billion SEK in exports, implying that the global growth remains in a volatile bottoming process. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades