Global

Special Report

Dear Client, We are sending you our last issue of the year, which contains a lighter fare than usual, highlighting 10 charts we find important. The first three charts tackle questions of Chinese growth, global activity and the outlook for the Federal Reserve. The other seven relate directly to the currency market. We will resume our regular publishing schedule on January 4th, 2019. The Foreign Exchange Strategy team would like to thank you for your continued readership and wish you and yours a joyful holiday season as well as a healthy, happy and prosperous 2019.   Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) Chinese Growth Outlook Since the 19th National Congress of the Communist Party of China, Beijing has been focused on controlling debt growth. The Chinese leadership is worried that too much debt will lead to the dreaded middle-income trap, whereby a country’s development stalls once it achieves middle-income status. Because of Beijing’s laser focus on debt, Chinese growth, especially in the industrial sector, has slowed. Yet in the second half of 2018, Chinese policymakers have grown concerned by the deepening malaise in the domestic economy. Consequently, they have loosened policy, accelerating the issuance of local government bonds, letting the repo rate fall to 2.7% and cutting the reserve requirement ratio to 14.5%. Despite these measures, credit growth has continued to slow, hitting 16-year lows, and crucially, the shadow banking system is still contracting (Chart 1, left panel). While the supply of credit remains tepid, declining demand for credit is more concerning. China’s marginal propensity to save, as approximated by the gap between the growth of M2 and M1 money supply, is still rising. Historically, a rising marginal propensity to save leads to slowing industrial activity and slowing import growth (Chart 1, right panel). This implies that China will continue to weigh on global trade and global industrial activity. Thus, to turn growth around, Chinese policymakers will need to ease policy further. Chart 1AChinese Growth Will Slow Further (I) Chart 1BChinese Growth Will Slow Further (II) 2) Global Growth And Inflation Outlook Already, the outlook for Chinese growth points to additional downside to global growth – something EM carry trades financed in yen are already sniffing out (Chart 2, left panel). The deterioration in the performance of those carry trades further amplifies the negative impulse emanating from China. If high-yielding EM currencies depreciate versus funding currencies like the yen, money is leaving those economies. Hence, EM liquidity conditions are tightening and financial conditions are deteriorating, reinforcing the leading property of EM carry trades vis-à-vis global industrial activity. Chart 2ASlowing Global Growth And Inflation (I) Chart 2BSlowing Global Growth And Inflation (II) Moreover, as telegraphed by the relative performance of EM bonds to EM equities, global inflation is set to peak soon, and then decelerate (Chart 2, right panel). This is a natural consequence of the deflationary impact of slowing Chinese growth and tightening EM liquidity conditions – the two most crucial factors lying behind the softness in global growth. Thus, financial markets are likely to remain volatile, at least until global policymakers have changed their tune enough to reverse global growth and inflation dynamics. 3) The Fed Is On Track To Hike More Than The Market Believes In its latest set of forecasts, the Federal Reserve may have been forced to adjust how much it will hike interest rates over the coming years. Nonetheless, by the end of 2020, the FOMC still anticipates having to increase interest rates by more than the -8 basis points currently priced into the futures curve. We are inclined to side with the Fed. U.S. growth may be slowing, but it will remain above trend in 2019. Additionally, the U.S. economy is most likely already at full employment, thus inflationary pressures are building. For the Fed, the labor market remains the fulcrum of potential inflation. As the left panel of Chart 3 shows, both the Atlanta Fed Wage Tracker and BLS average hourly earnings are growing at an accelerating pace, giving the Fed ammo to hike rates further. Moreover, the highly interest-sensitive housing sector has been a great source of concern for U.S. growth. However, now that this year’s surge in mortgage rates is being digested, mortgage applications are once again rebounding (Chart 3, right panel). This suggests that real estate activity will stabilize. Hence, even if the Fed pauses, it will still surprise markets to the upside over the coming 24 months. Chart 3AGood Reasons To Keep Hiking In 2019 Chart 3BGood Reasons To Keep Hiking In 2019 4) The Dollar Can Rally Even If U.S. Growth Falls Off A Cliff In our assessment, U.S. growth will slow next year, but will nonetheless remain above trend. However, if we are wrong and U.S. growth weakens much more, the dollar is unlikely to crater. As Chart 4 illustrates, periods of broad growth weakness – as measured by our U.S. economic diffusion index – often generate a strong – not weak – dollar. U.S. growth weakness often happens as global growth deteriorates. Since the U.S. economy exhibits a low beta to global industrial activity – the segment of the economy that contributes most to the variance in GDP growth – it follows that if a shock is global, the U.S. is likely to perform better than the rest of the world, leading to a strong dollar. Today, the downside risk is that the U.S. catches the cold that has hit the global economy. Hence, if U.S. growth has significantly more downside, it would suggest that economies outside the U.S. would suffer even more. The dollar should perform well in this environment. Chart 4The Dollar Doesn't Really Care If U.S. Growth Slows 5) The Dollar Versus Global Growth And Global Inflation The most important question to forecast the path of the dollar is where we stand in the global growth and inflation cycle. As Chart 5 shows, the dollar tends to perform most poorly early in the business cycle, when global growth is picking up but inflation remains muted (bottom-right quadrant), and late in the cycle when global growth has begun to weaken but inflation remains perky (top-left quadrant). The best time to hold the greenback is during global downturns, when both global growth and inflation are decelerating (bottom-left quadrant). With global industrial activity on a downtrend and inflation set to roll over soon, we are entering the bottom-left quadrant. As a result, the greenback should continue to rally on a trade-weighted basis, gaining most against the commodity currency complex. The yen may be the one currency bucking this trend, as in recent years it has become even more counter-cyclical than the dollar. 6) The Dollar Is A Momentum Currency One of the defining characteristics of the greenback is that from an investment-style perspective, it is a momentum currency. As the left panel of Chart 6 illustrates, among G-10 currencies, momentum continuation strategies work best for the USD. This is because of feedback loops present in the global economy. Chart 6BMomentum Still Flashing A Greenlight For The Greenback (II) Of the major economies, the U.S. is the least sensitive to global trade and global investment – a consequence of the low share of exports and manufacturing in GDP and employment. As a result, when global growth deteriorates, the U.S. economy experiences less of a slowdown and American rates of return decline less. Thus, money comes back into the U.S., lifting the dollar in the process. However, since there is USD 14-trillion in dollar-denominated foreign-currency debt, a rising dollar increases the cost of capital for these borrowers. The ensuing tightening in financial conditions hurts global growth, further enhancing the greenback’s appeal. The relationship goes in reverse once global growth improves. These powerful feedback loops explain why when the dollar strengthens, it remains stronger for longer than anyone anticipated, and vice versa when it weakens. Today, the momentum signal for the dollar remains positive (Chart 6, right panel). Along with slowing global growth, momentum was one of the key factors behind the dollar’s strength this year. If, as we expect, global inflation also weakens in the first half of 2019, the dollar will likely experience a beautiful first six months of the year. 7) Keep An Eye On Sino-U.S. Rate Differentials When one-year interest rate differentials between the U.S. and China widen, the DXY tends to strengthen (Chart 7, left panel). This is a reflection of global growth dynamics. U.S rates tend to rise relative to China when Chinese growth is decelerating. Since a slowing Chinese economy implies less intake of machinery and raw materials, a weaker China hurts Europe, Japan, EM and commodity producers a lot more than it affects the U.S. This lifts the dollar in the process. Moreover, so long as Chinese one-year interest rates keep falling versus the U.S., it also signals that any reflationary efforts by China have not yet had any impact on growth. Chart 7AU.S.-China Rate Differentials Point To A Stronger Dollar (I) Chart 7BU.S.-China Rate Differentials Point To A Stronger Dollar (II) This same rate differential between the U.S. and China also drives fluctuations in USD/CNY (Chart 7, right panel). Since falling relative Chinese rates are a symptom of a weaker Chinese economy, this relationship makes sense. Moreover, in recent years, more than against the dollar, Chinese policymakers have targeted the value of the CNY on a trade-weighted basis. Mechanically, if slowing Chinese growth flatters the trade-weighted dollar, it also forces USD/CNY up. This can further reinforce the strength in the broad trade-weighted dollar as a falling CNY is deflationary for the global economy. Because Chinese growth remains weak, we expect U.S. rates to continue to move higher vis-à-vis Chinese ones, lifting both the DXY and USD/CNY in the process. 8) EUR/USD: More Downside And A Complex Bottoming Process Ahead EUR/USD will suffer if global growth weakens and the dollar strengthens. On one hand, the European economy is much more sensitive to the Chinese and global industrial cycle than U.S. activity is. Our outlook for global growth therefore implies that the European Central Bank will find it difficult to raise rates in the fall of 2019, while the Fed is likely to surprise markets on the hawkish side. On the other hand, the simplest vehicle to bet on a strengthening dollar is to sell EUR/USD. Our fair-value model for EUR/USD currently pegs its equilibrium at 1.11 (Chart 8, left panel). However, EUR/USD never ends its downdrafts at its fair value – a consequence of its negative correlation with the dollar, a momentum currency that easily over- and under-shoots fair value. Thus, we expect the euro to find stability closer to 1.08. Chart 8AEUR/USD Will Bottom Later Next Year (I) Chart 8BEUR/USD Will Bottom Later Next Year (II) Moreover, inflationary dynamics do not suggest that EUR/USD is yet ripe for the taking. Since 2008, the gap between euro area and U.S. core CPI has been a reliable leading indicator for EUR/USD (Chart 8, right panel). In fact, this chart suggests that EUR/USD is more likely to bottom towards the second half of 2019; so as long as European inflation remains tepid, it will be hard for this currency to suddenly rebound and recoup the losses it has experienced this year. A complex bottom is more likely than a V-shaped one. 9) EUR/JPY: All About Bond Yields Even more so than USD/JPY, EUR/JPY remains beholden to trends in global bond yields (Chart 9). BCA’s view is that on a cyclical horizon of nine to 12 months, bond yields have upside. However, with global growth and inflation likely to decelerate further in the first half of 2019, safe haven assets could remain well bid over that timeframe. This implies the time to buy EUR/JPY is not now, and that a better buying opportunity will emerge once global growth stabilizes. Thus, we remain short EUR/JPY for the time being, a view we have held since the beginning of 2018. Chart 9Risks To Global Growth Equals EUR/JPY Downside 10) EUR/GBP Is At Risk At the current juncture, EUR/GBP is a binary bet: Either a hard Brexit comes to fruition, in which case U.K. real rates plummet and British inflation rises above 5%, creating a deeply pound-bearish environment. Alternatively, a soft Brexit (or even no Brexit) materializes, in which cases British real rates have upside, the Bank of England has a freer hand to combat inflationary pressures, and the pound can rally. With EUR/GBP currently trading toward the top of its historical distribution, we believe it is an attractive shorting opportunity (Chart 10). Marko Papic, BCA’s chief geopolitical strategist, assigns a less than 10% probability of a hard Brexit. As such, the pound is more likely to exist in a soft/no-Brexit world in 12 months than otherwise. This means the pound should be-revalued. Chart 10Sell EUR/GBP We prefer playing the pound’s strength against the euro rather than the dollar, as we expect the dollar to rally further in the first half of 2019, so cable would be swimming against the tide. Moreover, when the dollar strengthens, historically EUR/GBP weakens, as the GBP has a lower beta to the dollar than the euro does. Hence, our dollar view is also consistent with a lower EUR/GBP. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

We downgraded global equities this summer based on lofty valuations, overly bullish sentiment, and the prospect of slowing global growth. Since then, valuations have improved, sentiment has turned more cautious, and while global growth will continue to decelerate in the first half of 2019, asset markets have largely discounted this outcome. Consistent with this turn of events, our MacroQuant equity model is now sending a more upbeat signal on equities, while flagging a more challenging outlook for bonds. As such, we recommend that clients overweight global equities during the next 12 months, underweight government bonds, and move cash allocations from overweight back down to neutral. We discussed our key views for 2019 in this week’s report and they remain in place following today’s adjustments.  Today’s FOMC statement and press conference do not alter these conclusions. The Fed now expects to raise rates two times in 2019, down from three hikes in the September statement. The more gradual pace of rate increases reflects the tightening in financial conditions observed over the past few months as well as somewhat lower-than-expected inflation readings. Ultimately, we think the Fed will be able to raise rates at least three times next year as it becomes clear that the U.S. economy can tolerate tighter monetary policy. Higher U.S. rates, in conjunction with slowing Chinese growth, will keep the dollar well bid in the first half of next year, allowing U.S. stocks to outperform their foreign peers in dollar terms. In past reports, we highlighted our intention to go long the MSCI All-Country World index if the ACWI ETF reached $64. This occurred today and we are now long the index as part of our structural trade recommendations. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Special Report

We downgraded global equities this summer based on lofty valuations, overly bullish sentiment, and the prospect of slowing global growth. Since then, valuations have improved, sentiment has turned more cautious, and while global growth will continue to decelerate in the first half of 2019, asset markets have largely discounted this outcome. Consistent with this turn of events, our MacroQuant equity model is now sending a more upbeat signal on equities, while flagging a more challenging outlook for bonds. As such, we recommend that clients overweight global equities during the next 12 months, underweight government bonds, and move cash allocations from overweight back down to neutral. We discussed our key views for 2019 in this week’s report and they remain in place following today’s adjustments.  Today’s FOMC statement and press conference do not alter these conclusions. The Fed now expects to raise rates two times in 2019, down from three hikes in the September statement. The more gradual pace of rate increases reflects the tightening in financial conditions observed over the past few months as well as somewhat lower-than-expected inflation readings. Ultimately, we think the Fed will be able to raise rates at least three times next year as it becomes clear that the U.S. economy can tolerate tighter monetary policy. Higher U.S. rates, in conjunction with slowing Chinese growth, will keep the dollar well bid in the first half of next year, allowing U.S. stocks to outperform their foreign peers in dollar terms. In past reports, we highlighted our intention to go long the MSCI All-Country World index if the ACWI ETF reached $64. This occurred today and we are now long the index as part of our structural trade recommendations. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1.  Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming 2.  Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth   Chart 4Wider Spreads Bode Well For The Dollar   6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2).  Chart 5The MacroQuant Equity Score* Improves To Neutral   Chart 6Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market   Chart 8Recessions And Bear Markets Usually Overlap     Table 2Too Soon To Get Out 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S.   Chart 10Will The Late-1990s Pattern Be Repeated?   9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades