Japan

Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five 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-10 Short the 10-Year OAT Short the 10-Year OAT 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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of our country Monitors are now forecasting monetary policy on hold, apart from Australia and New Zealand where looser policy is warranted (Chart of the Week). However, with early leading indicators now flagging a trough in global growth, and with labor markets mostly tight, the Monitors may not signal a need for incremental easing since inflationary pressures have not decelerated much. Given how far global bond yields have fallen in response to the weaker growth backdrop over the past year, any sign of the Monitors finding a floor would herald a turnaround in overbought global government bond markets – most notably in the U.S. and core Europe, where a below-benchmark strategic duration stance is most appropriate. Feature Chart of the WeekA Synchronized Pullback In The BCA Central Bank Monitors A Synchronized Pullback In The BCA Central Bank Monitors A Synchronized Pullback In The BCA Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Bond Yields Have Fully Adjusted To Our CB Monitors Bond Yields Have Fully Adjusted To Our CB Monitors Bond Yields Have Fully Adjusted To Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocations for global government bonds reflect the trends seen in the Central Bank Monitors, even as they have all shifted lower. We are favoring countries where the Monitors are falling (Australia, the U.K., Japan, New Zealand and Canada) relative to regions where the Monitors appear to be stabilizing (the U.S., core Europe). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against money market yields curves (the spread between 1-year government bond yields and central bank policy rates, to measure expected changes in interest rates). Fed Monitor: No Rate Cuts Needed Our Fed Monitor has drifted lower over the past several months and now sits just above the zero line (Chart 3A). That indicates no pressure to hike interest rates, which is consistent with the Fed’s recent dovish turn. Yet the Monitor is also not yet in the “easier money required” zone that would suggest a need for the Fed to lower the funds rate - even though that is an outcome now discounted in the U.S. yield curve. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Yes, the U.S. has finally seen some negative impact from slower global growth and the late-2018 tightening of U.S. financial conditions. However, those factors are now starting to become less negative for growth – most notably the across-the-board rally in equity and credit markets in Q1 that has eased financial conditions. There is little danger of a shift to a sustained period of below-trend growth (i.e. less than 2%) in 2019 that would free up spare capacity, and ease inflation pressures, in the U.S. economy (Chart 3B).   Chart 3AU.S. Treasury Rally Looks Overdone U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BA Big Pullback In U.S. Inflation Is Unlikely A Big Pullback In U.S. Inflation Is Unlikely A Big Pullback In U.S. Inflation Is Unlikely Among the three sub-components of the Fed Monitor (growth, inflation and financial conditions), all are close to the zero lines (Chart 3C), suggesting that the current neutral signal from the Monitor is broad-based. The rally in the U.S. Treasury market now looks stretched, however, with the 10-year yield now lower than levels of a year ago – an outcome that, in that past, has usually coincided with the Fed Monitor falling well below zero (Chart 3D). A below-benchmark duration stance in the U.S. is appropriate, as the risk/reward profile favors higher Treasury yields from current depressed levels. Chart 3CFed Monitor Components All Near Zero, Validating Current Fed Pause Fed Monitor Components All Near Zero, Validating Current Fed Pause Fed Monitor Components All Near Zero, Validating Current Fed Pause Chart 3DU.S. Treasury Rally Looks Overdone U.S. Treasury Rally Looks Overdone U.S. Treasury Rally Looks Overdone BoE Monitor: The Window For A Rate Hike Has Closed Our Bank of England (BoE) Monitor, which had been in the “tighter money required” zone between 2016-18, has fallen back to the zero line (Chart 4A). The obvious culprit is the ongoing Brexit uncertainty, which has damaged confidence among both businesses and consumers. Overall economic growth has held in better than expected given the Brexit noise – for example, the manufacturing PMI now sits at 55.1, comfortably above the boom/bust 50 threshold. Yet leading economic indicators continue to deteriorate and growth is likely to remain under downward pressure in the coming months. Despite estimates showing a lack of spare capacity in the U.K. economy (a closed output gap, an unemployment rate well below NAIRU), both headline and core inflation have fallen back to the BoE’s 2% target (Chart 4B). The central bank has changed its policy bias as a result, with even the more hawkish members of the Monetary Policy Committee signaling that there is no longer any pressing need for rate hikes.   Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BU.K. Inflation Back To BoE Target U.K. Inflation Back To BoE Target U.K. Inflation Back To BoE Target When looking at the split between the growth and inflation components of our BoE Monitor, it is clear that the former has triggered the large fall in the Monitor (Chart 4C). Yet even the inflation component has fallen below the zero line. With no pressure from any corner to alter monetary policy, the BoE can continue to sit on its hands and wait for some clarity to develop on the Brexit front. Chart 4CHit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold Hit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold Hit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold We continue to recommend overweighting U.K. Gilts within global government bond portfolios, given the weakening trend in U.K. leading economic indicators and persistent Brexit uncertainty (Chart 4D). Chart 4DA Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields A Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields A Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields ECB Monitor: Bund Yields Have Fallen Too Far Our European Central Bank (ECB) Monitor is slightly below the zero line, signaling no real need for any change to euro area monetary policy (Chart 5A). The sharp slowing of economic growth last year, driven primarily by plunging exports, is the main reason why the Monitor has stayed subdued. Despite the weaker growth momentum, however, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Inflation More Stable At Full Employment Euro Area Inflation More Stable At Full Employment Euro Area Inflation More Stable At Full Employment   Nonetheless, the ECB has already back-pedaled on policy normalization announced last December. The central bank announced a new program of cheap funding for euro area banks (TLTRO3) to begin this September, replacing the expiring loans from the previous funding program. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor. There are some tentative signs that euro area growth may be stabilizing, such as increases in the expectations component of the ZEW and IFO surveys. If this is the beginning of a true cyclical turnaround, then the downward pressure on our ECB Monitor from a weak economy will soon reverse (Chart 5C). Chart 5COffsetting Growth & Inflation Components In The ECB Monitor Offsetting Growth & Inflation Components In The ECB Monitor Offsetting Growth & Inflation Components In The ECB Monitor The ECB is now signaling that it will keep policy rates unchanged until the end of the year, on top of the new TLTRO. In addition, faster global growth in the latter half of 2019 will provide a boost to the euro area economy via the export channel. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor (Chart 5D). We recommend only a neutral allocation to core European government bonds, but our next move is likely a downgrade. Chart 5DBund Rally Looks Stretched Versus ECB Monitor Bund Rally Looks Stretched Versus ECB Monitor Bund Rally Looks Stretched Versus ECB Monitor BoJ Monitor: No Inflation, No Change In Policy Our Bank of Japan (BoJ) Monitor has drifted back to the zero line after a brief cyclical stay in the “tighter money required” zone in 2017/18 (Chart 6A). Such is life in Japan, where even an unemployment rate of 2.3% – the lowest in decades – cannot generate inflation outcomes anywhere close to the BoJ’s 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation The slowing of global trade activity and weakness in Chinese economic growth has hit the export-sensitive Japanese economy hard. Industrial production is now contracting, export volumes fell –6.8% year-over-year in January, and the widely-followed Tankan survey showed the biggest quarterly drop in business confidence among manufacturers in Q1/2019 since 2011. Household confidence has also taken a hit and retail sales growth has stagnated. Against such a weak economic backdrop, the soft growth component of our BoJ Monitor is fully offsetting the relative strength of the inflation component (Chart 6C). The latter is mostly related to the tightness of Japan’s labor market, which has pushed nominal wage inflation to 3.0% - the fastest pace since 1990. Core inflation at 0.4% has not followed suit, however. Chart 6CStill Not Enough Growth To Justify Any Reduction in BoJ Accommodation Still Not Enough Growth To Justify Any Reduction in BoJ Accommodation Still Not Enough Growth To Justify Any Reduction in BoJ Accommodation We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings – especially compared to the rest of the developed markets – until there is much higher realized core inflation in Japan. There is no chance of the BoJ moving any part of the Japanese yield curve it effectively controls (all interest rates with maturity of 10 years of less) until both growth and inflation move durably higher (Chart 6D). Chart 6DNo Pressure On JGB Yields To Rise No Pressure On JGB Yields To Rise No Pressure On JGB Yields To Rise BoC Monitor: Neutral Across The Board Our Bank of Canada (BoC) Monitor has fallen sharply since mid-2018 and now sits right at the zero line, suggesting no pressure to change monetary policy (Chart 7A). The main cause is weakness in the Canadian economy, which has responded negatively to the combination of previous BoC rate hikes, diminished business confidence and slower global growth. The central bank was surprised by how rapidly the Canadian economy lost momentum at the end of last year, when real GDP expanded an anemic 0.4% annualized pace in Q4/2018. That prompted the BoC to signal a halt to the rate hikes, even with core inflation measures hovering close to the midpoint of the BoC’s 1-3% target band (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BIs Economic Slack Underestimated In Canada? Is Economic Slack Underestimated In Canada? Is Economic Slack Underestimated In Canada? Canadian money markets now discount -20bps of rate cuts over the next year. In the past, market pricing of BoC rate expectations has tended to be more correlated to the inflation component of our BoC Monitor (Chart 7C). The latest downturn in the Monitor, however, has been driven by declines in both the growth and inflation components. The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7CBoC Monitor Components Both Consistent With No Change In Interest Rates BoC Monitor Components Both Consistent With No Change In Interest Rates BoC Monitor Components Both Consistent With No Change In Interest Rates We closed our long-standing underweight recommended allocation for Canadian government bonds on March 19.1 We are now at neutral weight, although we may shift to an overweight stance if the coming rebound in global growth that we expect does not carry over into the Canadian economy and trigger some stabilization in our BoC Monitor (Chart 7D). The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7DCanadian Yields Will Not Rise Again Without A Rebound In Growth Canadian Yields Will Not Rise Again Without A Rebound In Growth Canadian Yields Will Not Rise Again Without A Rebound In Growth RBA Monitor: More Pressure To Cut Rates The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). A slumping economy has been weighed down by sluggish consumption, weak exports and falling house prices in the major cities. Combined with inflation stubbornly below the 2-3% RBA target band, this has driven Australian bond yields to new lows. -41bps of RBA rate cuts over the next year are now discounted in the Australian OIS curve. Delivering on those rate cut expectations, however, will likely require some weakening of the labor market (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor As depicted in Chart 8C, both the growth and inflation components of our RBA Monitor have fallen below the zero line. Over the past quarter-century, when both components of the RBA Monitor were as far below zero as they are now, shorter-dated bond yields have ended up falling below the Cash Rate as markets move to price in an easing cycle. That 1-year/Cash Rate spread has not yet gone negative, suggesting there is more room for the entire Australian government yield curve to be dragged lower by the front-end if the economy does not soon improve. Chart 8CSoft Inflation Is Why Our RBA Monitor Is Calling For Cuts Soft Inflation Is Why Our RBA Monitor Is Calling For Cuts Soft Inflation Is Why Our RBA Monitor Is Calling For Cuts The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive. The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive (Chart 8D). With Australia’s leading economic indicator still decelerating, and with any boost to exports not likely until later this year, we continue to recommend an overweight stance on Australian government bonds. Chart 8DStay Long Australian Bonds Stay Long Australian Bonds Stay Long Australian Bonds RBNZ Monitor: Setting Up For A Rate Cut Our Reserve Bank of New Zealand (RBNZ) monitor has been below the zero line since September 2018, indicating that easier monetary policy is required. (Chart 9A). The central bank made a significant dovish shift in its forward guidance at the March meeting, noting that the balance of risks for the New Zealand (NZ) economy was now tilted to the downside and the next move is more likely to be a rate cut. That dovish turn is consistent with the underwhelming performance of NZ inflation (Chart 9B). The RBNZ does not expect inflation to hit 2% until the end of 2020, even with the unemployment rate at a ten-year low of 4.3% and wages growing at a 2.9% annual rate. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Has Struggled To Breach 2% NZ Inflation Has Struggled To Breach 2% NZ Inflation Has Struggled To Breach 2% Over the past two decades, market pricing of RBNZ rate moves has been more correlated to the growth component of our RBNZ Monitor. In the years since the Global Financial Crisis, however, the growth and inflation components have been highly correlated to each other and to expectations for interest rates (Chart 9C). With markets now discounting -45bps of rate cuts over the next year, the NZ yield curve appears appropriately priced relative to our RBNZ Monitor. Chart 9CBoth Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts Both Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts Both Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts We have maintained a bullish recommendation on NZ government bonds versus both U.S. Treasuries and German Bunds since mid-2017, and we see no reason to close this highly profitable position, even if the RBNZ fails to fully deliver on discounted rate cuts. Both Treasuries and Bunds look overvalued amid signs of U.S. and European growth stabilizing, while the deterioration in our RBNZ Monitor suggests NZ yields have far less upside (Chart 9D). Chart 9DStay Long New Zealand Government Bonds Stay Long New Zealand Government Bonds Stay Long New Zealand Government Bonds Riksbank Monitor: Rate Hikes Delayed, Rate Cuts Unlikely Our Riksbank Monitor is currently slightly below zero and market is now priced for -17bps of rate cuts over next year (Chart 10A). The market has judged that the recent bout of weaker Swedish economic data has effectively derailed the Riksbank’s plans to hike rates in the second half of 2019. However, given the dearth of spare capacity in the Swedish economy (Chart 10B), and with the policy rate still negative, rate cuts are unlikely to be delivered. At best, the central bank can delay rate hikes if growth continues to disappoint, which also supports easier monetary conditions via a weaker exchange rate (the krona is down -4.7% year-to-date). Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Inflation Cooling Off A Bit Sweden Inflation Cooling Off A Bit Sweden Inflation Cooling Off A Bit The Riksbank stated in its February Monetary Policy Report that low Swedish productivity growth is leading to cost pressures through higher unit labor costs. It also forecasts that faster wage growth over the next year will help keep inflation near the 2% Riksbank target. The implication is that it will take much weaker growth, and higher unemployment, before the central bank will completely abandon its quest to normalize Swedish interest rates. The relationship between the growth/inflation components of our Riksbank Monitor and the market’s interest rate expectations has been weak since the central bank cut rates below zero and introduced quantitative easing in late 2014 (Chart 10C). Prior to that, however, it was the growth component that was more correlated to short-term interest rate expectations. On that note, the rebound in global growth that we are expecting will help support the Swedish economy, which is highly geared to global economic activity, and put a floor under Swedish bond yields (Chart 10D). Chart 10CRiksbank Can Stay On Hold Riksbank Can Stay On Hold Riksbank Can Stay On Hold Chart 10DNo Pressure For Higher Sweden Bond Yields No Pressure For Higher Sweden Bond Yields No Pressure For Higher Sweden Bond Yields Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see Global Fixed Income Weekly Report “March Calmness,” published March 19, 2019. Available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Validating The Dovish Turn BCA Central Bank Monitor Chartbook: Validating The Dovish Turn Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Quarterly - April 2019 Quarterly - April 2019 Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Market Doesn't Believe The Fed's Target Market Doesn't Believe The Fed's Target Table 1Fed Won’t Be Able To Cut This Much Next Time Quarterly - April 2019 Quarterly - April 2019   Chart 2Financial Conditions Now Much Easier Financial Conditions Now Much Easier Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Housing Market Bottoming Out Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth Some "Green Shoots" For Global Growth Some "Green Shoots" For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Fed Still Below Neutral Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus Ex US Equities Driven By China Stimilus Ex US Equities Driven By China Stimilus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Oil, Positioning, And Housing Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Declining Quality In Investment Grade Declining Quality In Investment Grade Chart 11 Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound? A Value Rebound A Value Rebound Chart 14   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Watch Earnings Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Warming Up To The Euro Area Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Becoming Less Defensive Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Rates: Likely More Upside Risk Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers Favor Inflation Linkers Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit Tactical Upside Remains For Credit Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Prefer Oil, Watch Metals Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market The End Of The Dollar Bull Market The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Yield Curve Inversion Yield Curve Inversion Chart 27How Much Is China Reflating? How Much Is China Reflating? How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Highlights Investors should use the following dynamic for tactical asset allocation: 1. Sum the 10-year yields on the T-bond, German bund, and JGB. 2. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. 3. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways. 4. When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities (Chart of the Week). 5. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds. Right now, with the sum near 3 percent, it is still appropriate to be overweight equities versus bonds, and our preferred expression is overweight the DAX versus the German long bund. Feature Chart of the WeekThe Rule Of 4 Becomes The Rule Of 3 The Rule Of 4 Becomes The Rule Of 3 The Rule Of 4 Becomes The Rule Of 3 The global long bond yield recently hit a two-year low (Chart I-2). This is the direct result of central banks’ pivot to dovish – a commitment to keep policy rates at current levels, rather than to hike, for the foreseeable future. Chart I-2The Global Long Bond Yield Recently Hit A Two-Year Low The Global Long Bond Yield Recently Hit A Two-Year Low The Global Long Bond Yield Recently Hit A Two-Year Low One consequence is that high-quality bonds have become riskier. Consider a German bund or a JGB which is yielding zero percent. The short-term potential for capital appreciation – nominal or real – has almost vanished, while the potential for vicious losses has increased dramatically. The technical term for this negative asymmetry is negative skew. Years of research in a field of behavioural economics called Prospect Theory concludes that negative skew is the metric that best encapsulates investment risk. The Correct Way Of Thinking About Investment Risk A great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional sense. After all, who minds when their asset price goes up sharply? Risky assets are risky because they have the propensity to experience much larger short-term losses than short-term gains – captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. High-quality bonds have become riskier. Another great misunderstanding of finance is the idea that bonds offer a diversification benefit and, therefore, that investors should accept a lower return from them. This argument is also flawed. The bond market is bigger than the equity market, and just as bonds are a diversifier for equity investments, equities are a diversifier for bond investments. Indeed, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump’s shock victory in 2016. So we could equally argue that equities offer a diversification benefit. In fact, the correct way of thinking about investment risk is as follows: An investment’s risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns (Chart I-3). This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher (Chart I-4). But when bond yields normalize, equities regain their excess riskiness versus bonds – and their valuations must suffer a phase transition sharply lower. The phase transition in equity valuations is most pronounced when the global 10-year bond yield goes up or down through 2 percent (Chart I-5). Chart I-3 Chart I-4 Chart I-5 This dynamic proved to be the biggest driver of asset allocation in 2018, and is likely to be a big driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse. The unsurprising response from central banks is to pivot back to dovish, pulling back bond yields to previous lows. These lower bond yields then push up equity (and other risk-asset) valuations back to previous highs. An investment’s risk depends on the negative asymmetry of its short-term returns. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or decline further. But the longer-term danger is that these rich valuations are hyper-sensitive to rising bond yields. The Bubble In Everything The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets. Extraordinary monetary policy has boosted the valuations of all risk-assets across all geographies and all asset-classes. By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes – equities (Chart I-6), credit (Chart I-7), and real estate (Chart I-8). This makes it considerably more dangerous, because we estimate that the total value of global risk-assets including real estate is $400 trillion, equal to about five times the size of the global economy.1 Chart I-6Equities Remain Richly Valued Equities Remain Richly Valued Equities Remain Richly Valued Chart I-7Credit Remains Richly Valued Credit Remains Richly Valued Credit Remains Richly Valued Chart I-8The EM Real Estate Boom Happened After 2008 The EM Real Estate Boom Happened After 2008 The EM Real Estate Boom Happened After 2008 Let’s say you had a risk-asset that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today’s price must surge by 63 percent.2 If you were prudent, you might amortise today’s windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. The total value of global risk-assets equals five times the size of the global economy. Now let’s imagine a valuation derating moves the risk-asset’s returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The Rule Of 4 Becomes The Rule Of 3 How can we sense the crucial 2 percent level in the global 10-year bond yield? The answer is that it broadly equates to when the sum of the 10-year yields on the T-bond, German bund and JGB is at a 4 percent level (Chart I-9). This is the genesis of our very successful ‘Rule of 4’. In 2019, just as in 2018, investors should use the following dynamic for tactical asset allocation. The rule of 4 identifies when the global 10-year bond yield is at 2 percent. Chart I-9When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent  Sum the 10-year yields on the T-bond, German bund, and JGB. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways.  When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds (Chart I-10). Overweight equities versus bonds. With the sum of the three 10-year yields now near 3 percent, the rule of 4 has, in a sense, become the rule of 3. It is still appropriate to be tactically overweight equities versus bonds, and our preferred expression is to overweight the DAX versus the German long bund. Chart I-10Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Trapped: Have Equities Trapped Bonds?”, September 13, 2018 available at eis.bcaresearch.com. 2 5 percent compounded over ten years.

Highlights Every diversified currency portfolio should hold the yen as insurance against rising market volatility. However, for tactical investors, the latest dovish shift by global central banks almost guarantees the Bank of Japan will err on the side of stronger stimulus (explicitly or indirectly). Our bias is that USD/JPY could trade sideways in the next three to six months, but EUR/JPY could test 132 by year-end. Carefully monitor any shift in yen behavior in the coming months, in particular its role as a counter-cyclical currency. Investors who need to hedge out sterling volatility should favor GBP calls. Hold onto the USD/SEK shorts established last week, currently 1.6% in the money. USD/NOK shorts are looking increasingly attractive, as will be discussed in next week’s report. Feature The yen has proven an extremely tough currency to forecast in the last few years. Carry-trade investors who used widening interest rate differentials between the U.S. and Japan in 2018 to forecast yen weakness got decimated in the February and March 2018 equity drawdowns. More agile investors who timed the global equity market bottom in early 2016 have been shifted to the wayside on yen shorts, as the currency has strengthened since then. For value-based investors, the yen that was 14% cheap on a fundamental basis in 2015 is 19% cheaper vis-à-vis fair value today. Seasoned investors recognize the need to pay heed to correlation shifts, as they can make or break forecasts. In the currency world, the most recent have been dollar weakness after the Federal Reserve first tightened policy in December 2016, dollar weakness in 2017 despite four Fed rate hikes and more recently, yen resilience despite the equity market rally since 2016. In this report, we revisit traditional yen relationships to identify which have been broken down, and which still stand the test of time. Trading Rules A rule of thumb still holds true for yen investors: buy the currency on any equity market turbulence (Chart I-1). In of itself, this advice is not sufficient. If one could perfectly time equity market corrections, being long the yen will be low on a long list of alpha-generating ideas. Chart I-1The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency The power of the signal comes when macroeconomic conditions, valuations and investor sentiment all align in a unifying message. Back in late 2016, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the Bank of Japan (BoJ). Having recently introduced yield curve control (YCC), the market was grappling with the dovish implications for the currency, arguably the most significant change in monetary policy by any central bank over the last several years. In retrospect, this was the holy grail for any contrarian investor. Given that backdrop, the yen strengthened by circa 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 for the yen rally. This backdrop underlines the golden rule for trading the yen, primarily as a safe-haven currency. Economically, the net international investment position of Japan is almost 60% of GDP, one of the largest in the world. On a yearly basis, Japan receives almost 4% of GDP as income receipts, which more than offsets the trade deficit it has been running since the middle of last year (Chart I-2). It is therefore easy to see why any volatility in markets could lead to powerful repatriation flows back to Japan. Chart I-2Japan's Income Receipts Are Quite Large Japan's Income Receipts Are Quite Large Japan's Income Receipts Are Quite Large One other factor to consider is that during bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows (Chart I-3). Chart I-3Hedging Costs Have Risen Hedging Costs Have Risen Hedging Costs Have Risen The global picture today has some echoes from 2016. Growth is slowing everywhere and markets have staged a powerful bounce from the December lows. This has been in anticipation of a better second half of this year. In the occasion that data disappointments persist beyond the first half, especially out of China, stocks will remain in a “dead zone,” which will be potent fuel for the yen. This is not our baseline scenario, as we expect growth to bottom in the second half of this year, but it remains an important alternative to consider at a time when Japanese growth is surprising to the downside. If the BoJ is preemptive and eases monetary policy, the yen will weaken. But the odds are highly in favor of the yen strengthening before. Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. The BoJ’s Next Move By definition, any data dependent central bank will be behind the curve, but the incentive for the BoJ to act preemptively this time around is getting stronger. The starting point is that history suggests the consumption tax hike, scheduled for October this year, will be disastrous for the economy. Since the late 1990s, every time the consumption taxed 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 highly unpalatable outcome (Chart I-4). More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is slowing, with growth in the third quarter of last year clocking in at -2.4%. Chart I-4The Consumption Tax Hike Will Be Negative The Consumption Tax Hike Will Be Negative The Consumption Tax Hike Will Be Negative However, things are not that simple for the Japanese Prime Minister Shinzo Abe’s administration. Despite relatively robust economic conditions since the Fukushima disaster, consumption has remained tepid, even though there has been tremendous improvement in labor market conditions. By the same token, the savings ratio for workers has surged (Chart I-5). If consumers are caught in a Ricardian equivalence negative feedback loop,1 exiting deflation becomes a pipe dream for the central bank. Chart I-5Strong Labor Market, Weak Consumption Strong Labor Market, Weak Consumption Strong Labor Market, Weak Consumption The good news is that the government realizes this and has been taking steps to remedy the situation. At the margin, this is positive: The Japanese government recently passed a law that will allow the largest inflow of foreign workers into the country. There are about 1.5 million foreign workers in Japan today, who collectively constitute circa 2% of the labor force. The importance of foreign labor cannot be understated. Due to Japan’s demographic cliff, foreign workers were responsible for 30% of all new jobs filled 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 go a long way in alleviating the country’s chronic labor shortage. This will also be marginally beneficial for consumption. Abe’s government hopes to offset the consumption tax hike with increased social security spending, especially on child education. For example, preschool and tertiary education will be made free of charge, financed by the tax hike. Labor reform has gone a long way to increase the participation ratio of women in the labor force (Chart I-6), but the reality is that almost 50% of single mothers in Japan still live below the poverty line, according to the BoJ. This is because many of them remain temporary workers. Temporary workers receive about half the pay of full-time workers’ and are not privy to most social security benefits. This has contributed to the surge in the worker’s savings ratio. Alleviating this source of uncertainty could help solve the consumption problem. Chart I-6Rising Female Participation In The Labor Force Rising Female Participation In The Labor Force Rising Female Participation In The Labor Force 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. Increasing the share of cashless payments will help lift the velocity of money, which will be a positive development for the BoJ (Chart I-7). Chart I-7Money Velocity Is Still Falling Money Velocity Is Still Falling Money Velocity Is Still Falling Finally, the Phillip’s curve appears to be finally working in Japan, with wages accelerating at a 1.4% pace. Provided the government continues to indirectly put pressure on big firms to raise wages by at least 2-3% in upcoming Shunto wage negotiations, this trend should continue. An extended period of rising wages will help shift the adaptive mindset of Japanese households away from deflation (Chart I-8). Chart I-8Rising Wages Will Help At The Margin Rising Wages Will Help At The Margin Rising Wages Will Help At The Margin The BoJ pays attention to three main variables when looking at inflation: Core CPI prices, the GDP deflator and the output gap, in addition to other measures. The recent slowdown in the economy has tipped two of those indicators in the wrong direction (Chart I-9). This makes it difficult for the Abe administration to declare victory over deflation – something he plans to do before his term expires by September 2021. Chart I-9Inflation Variables Are Softening Inflation Variables Are Softening Inflation Variables Are Softening The perfect cocktail for the Japanese economy will be expansionary monetary and fiscal policy. But despite government efforts to offset the consumption tax hike with higher spending, the IMF still projects the fiscal drag in Japan to be 0.7% of GDP in 2019. This puts the onus on the BoJ to ease financial conditions. At minimum, this suggests that either the stealth tapering of asset purchases by the BoJ could reverse and/or new stimulus could be announced. Bottom Line: The swap markets are currently pricing some form of policy easing in Japan over the next 12 months. Ditto for Japanese banks (Chart I-10A and Chart 10B). Given the recent dovish shift by global central banks, the probability of a move by the BoJ has risen. Any surprise move will initially strengthen USD/JPY. However, given the probability that the dollar weakens in the second half of this year, our bias will be to fade this move. Portfolio investors can use this as an opportunity to buy insurance, should markets become turbulent in the next few months. Chart I-10AThe Market Is Pricing In A Dovish BoJ (1) The Market Is Pricing In A Dovish BoJ (1) The Market Is Pricing In A Dovish BoJ (1) Chart I-10BThe Market Is Pricing In A Dovish BoJ (2) The Market Is Pricing In A Dovish BoJ (2) The Market Is Pricing In A Dovish BoJ (2) Corporate Governance, Profits And The Equity/Yen Correlation Once global growth eventually bottoms, 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). Depending on whether investors choose to hedge these inflows or not, this will dictate the yen’s path. At present, the cost of hedging does not justify sterilizing portfolio flows (see Chart I-3). Chart I-11Corporate Governance Could Lift Return On Capital Corporate Governance Could Lift Return On Capital Corporate Governance Could Lift Return On Capital The traditional negative relationship between the yen and the Nikkei still holds (Chart I-12). Weakening global growth is negative for the export-dependent Nikkei, and positive for the yen. This is because weakening global growth dips Japanese inflation expectations, and leads to higher real rates. This tends to lift the cost of capital for Japanese firms. Chart I-12The Yen/Equity Correlation Could Shift The Yen/Equity Correlation Could Shift The Yen/Equity Correlation Could Shift That said, another factor has been at play. Over the past few years, an offshoring of industrial production has been eroding the benefit of a weak yen/strong Nikkei. In a nutshell, if company labor costs are no longer incurred in yen, then the translation effect for profits is minimized on currency weakness. Investors will need to monitor the equity market/yen correlation over the next few years. It remains deeply negative, but could easily shift, dampening the yen’s counter-cyclical nature. Back in the 80s and 90s, the yen did shift into a pro-cyclical currency. Bottom Line: A dovish shift is increasingly likely by the BoJ. Meanwhile, our bias remains that if markets rebound in the second half of this year, this will be marginally negative for JPY. This could also put EUR/JPY near 132 by year end. A Few Notes On The Pound Recent market developments have become incrementally bullish for sterling. After Tuesday’s second defeat for Prime Minister Theresa May's Brexit deal, and again Wednesday’s rejection of a no-deal Brexit by 312 votes to 308, the probability is rising that the U.K. will either forge a deal for a more orderly separation with the EU or hold a new referendum altogether. Tuesday’s loss was expected because the EU had not offered a viable compromise to the Irish backstop - a deal that will keep Northern Ireland in the EU customs union beyond the transition date of December 2020. Meanwhile, Wednesday’s vote to leave the union sans arrangement was simply unpalatable for Parliament, given economics 101. Almost 50% of U.K. exports go to the E.U. A no-deal Brexit at a time when global exports are in a soft patch, and with much higher tariffs, was a no go for the majority.2 Complete sovereignty of a nation is and has always been a desirable fundamental right. For the average U.K. voter that has not benefited much from globalization, the risk was that Parliament repeatedly failed to pass a motion asking for an extension to the March 29 deadline. As we go to press, this risk has faded as MPs have voted 412 to 202 for a delay. An extension will likely be granted till the May 23-26 EU elections. The preference for an extension has been echoed by EU Commissioner President Jean-Claude Junker, Chief Negotiator Michel Barnier and Dutch Prime Minister Mark Rutte, all heavyweights in this imbroglio. For sterling investors, what is clear is that developments over the next few weeks will be volatile, but increasingly bullish. Admittedly, GBP has already rallied from its December lows. But long-term GBP calls still remain cheap, despite rising volatility (Chart I-13). Our fundamental models also suggest cable is cheap relative to its long-term fair value and it will be tough to the pound to depreciate if the dollar weakens in the second half of this year (Chart I-14). Chart I-13GBP Calls Are Cheap GBP Calls Are Cheap GBP Calls Are Cheap Chart I-14The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap Bottom Line: The probability of a no-deal Brexit has fallen. Going forward, risk reversals suggest sterling calls remain relatively cheap to puts. Investors who need to hedge out any sterling volatility should therefore favor GBP calls. Housekeeping Our short AUD/NZD position hit its target of 1.036 this week. We are closing this trade for a 7% profit. As highlighted in last week’s report,3 a lot of bad news is already priced into the Australian dollar, which is down 37% from its 2011 peak. Outright short AUD bets are therefore at risk from either upside surprises in global growth, or simply the forces of mean reversion.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. 2 Please see Geopolitical Strategy Weekly Report, titled “The Witches’ Brew Keeps Bubbling…,” dated March 13, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled “Into A Transition Phase,” dated March 8, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data in the U.S. continue to soften: The nonfarm payrolls came in at 20k in February, missing the forecast by 160k. Core consumer prices in February decelerated to a 2.1% year-on-year growth. Nonetheless, February average hourly earnings increased 3.4% year-on-year. Moreover, the unemployment rate in February fell to 3.8%. Lastly, retail sales in January grew at 0.2% month-on-month, outperforming expectations. The DXY index depreciated by 0.7% this week. The U.S. economy keeps growing above trend, but at a slower pace than last year. During the 60 minutes interview with CBS last weekend, Federal Reserve Chair Jerome Powell emphasized that while it is difficult for the economy to keep growing near 4% every year, it remains very healthy and any near-term recession is unlikely. We favor underweighting the dollar as we enter into a transition phase, where non-U.S. growth outperforms. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been promising: German factory orders in January came in at -3.9% year-on-year, improving from the last reading of -4.5%. The euro area industrial production month-on-month growth came in at 1.4% in January, outperforming expectations. In France, the Q4 nonfarm payrolls increased to 0.2% quarter-on-quarter, double the forecast. German consumer prices stayed at 1.7% year-on-year in February. EUR/USD appreciated by 1.2% this week. We favor overweighting the euro as easing financial conditions put a floor under growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: M2 money supply missed expectations in February, coming in at 2.4%. Besides, machine tool orders fell by -29.3% year-on-year in February. Total machinery orders were also weak in January, coming in at -2.9% on a year-on-year basis. Lastly, foreign investment in Japanese stocks was -1.2 trillion yen, while investment in Japanese bonds fell to 245.7 billion yen. USD/JPY has been flat this week. A dovish move by the BoJ is likely and it could further cheapen the yen. If global growth bottoms in the later half of this year, this will be bad news for the yen, given its counter-cyclical nature. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: In January, industrial production and manufacturing production both outperformed expectations, with industrial production coming in at -0.9% year-on-year and manufacturing production coming in at -1.1% year-on-year. GDP growth in January came in at 0.5% month-on-month, higher than expectations. GBP/USD appreciated by 1.1% this week. Cable rallied after the parliament vote on Wednesday. The sentiment remains positive since chances of a no-deal Brexit have diminished. We recommend long-term call options on cable to capture any upside potential. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia continue to deteriorate: Home loan growth in January contracted to -2.6%. The National Australian Bank business confidence index fell to 2 in February, while the business conditions index fell to 4. Consumer confidence in March decreased to -4.8%. AUD/USD moved up by 0.4% this week. The housing market and overall economy continue to weaken in Australia. However, the Australian dollar is at a 10-year low suggesting much of the bad news is priced in. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Electronic card retail sales came in at 3.4% yoy, slightly lower than the previous reading of 3.5%. Food price index in February fell to 0.4% month-on-month. NZD/USD increased by 0.9% this week. We remain underweight NZD/USD, on overvaluation grounds. We are also closing our short AUD/NZD position for a 7% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have confirmed robust labor market conditions: The unemployment rate in February came in line at 5.8% while the participation rate increased to 65.8%. New jobs created in February were 55.9k, the strongest since 1981, beating analysts’ forecasts of zero job creation. February average hourly wage growth also increased to 2.25% year-on-year. However, housing starts in February fell to 173.1k, underperforming expectations. USD/CAD fell by 0.6% this week. The Canadian economy, especially the housing sector continues to show signs of weakness, despite a strong labor market. The risk is that overvaluation in the housing market and elevated debt levels impair consumer spending power. While the rising oil price helps, we think the benefits are more marginal than in the past. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: Producer and import price growth in February fell to -0.7% year-on-year. EUR/CHF appreciated by 0.3% this week. Our long EUR/CHF trade is now 0.5% in the money since initiated on December 7, 2018. We continue to favor the euro versus the swiss franc as the later benefits less from a bottoming in global growth. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mostly positive: Overall consumer price inflation in February fell to 3% year-on-year; however, core inflation increased to 2.6% yoy. Producer prices also increased by 8% year-on-year in February. USD/NOK depreciated by 1.8% this week. Our long NOK/SEK trade is 2.8% in the money over two months. We continue to overweight NOK due to the cheap valuations and rising oil prices. The pickup in inflation also allows the Norges bank to become incrementally hawkish. 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 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been disappointing: In February, consumer price inflation fell to 1.9% yoy. The unemployment rate climbed to 6.6% in February. USD/SEK depreciated by 1.5% this week, mainly due to the recent weakness in the dollar. We remain positive on the SEK versus USD based on an expected pickup in the Swedish economy and cheap valuations. 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

Highlights Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. Investors should overweight stocks and spread product while underweighting safe government bonds over a 12-month horizon. The U.S. dollar will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Stronger global growth and a weaker dollar in the back half of the year will benefit EM assets and European stocks. Feature I skate to where the puck is going to be, not to where it has been. — Wayne Gretzky How To Be A Good Macro Strategist To paraphrase Gretzky, a mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. How can one predict how the economic data will evolve? Examining forward-looking indicators is helpful, but it is not enough. One also has to understand why the data is evolving the way it is. If one knows this, one can then assess whether the forces either hurting or helping growth will diminish, intensify, or remain the same.  What Accounts For the Growth Slowdown? There is little mystery as to why global growth slowed in 2018. Chinese credit growth fell steadily over the course of the year, which generated a negative credit impulse. Unlike in the past, China is now the most important driver of global credit flows (Chart 1). Chart 1Global Credit Flows Are Increasingly Driven By China Global Credit Flows Are Increasingly Driven By China Global Credit Flows Are Increasingly Driven By China Meanwhile, the global economy was rocked by rising oil prices. Brent rose from $55/bbl on October 5, 2017 to $85/bbl on October 4, 2018. Government bond yields also increased, with the 10-year U.S. Treasury yield rising from 2.05% on September 7, 2017 to 3.23% on October 5, 2018 (Chart 2). Chart 2Rising Oil Prices And Bond Yields Contributed To Slower Global Growth Last Year Rising Oil Prices And Bond Yields Contributed To Slower Global Growth Last Year Rising Oil Prices And Bond Yields Contributed To Slower Global Growth Last Year A mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. In an ironic twist, Jay Powell’s ill-timed comment that rates were “a long way” from neutral marked the peak in bond yields. Unfortunately, the subsequent decline in yields was accompanied by a vicious stock market correction and a widening in credit spreads. This led to an overall tightening in financial conditions, which further hurt growth (Chart 3). Chart 3Financial Conditions Tightened In 2018, Especially After Powell's Hawkish Comments Financial Conditions Tightened In 2018, Especially After Powell's Hawkish Comments Financial Conditions Tightened In 2018, Especially After Powell's Hawkish Comments The critical point is that all of these negative forces are behind us: Financial conditions have eased significantly over the past two months; oil prices have rebounded, but are still well below their 2018 highs; and as we explain later on, Chinese growth is likely to bottom by the middle of this year. This means that global growth should start to improve over the coming months. The United States: Better News Ahead The latest U.S. economic data has been weak, with this morning’s disappointing ISM manufacturing print being the latest example. The New York Fed’s GDP Nowcast is pointing to annualized growth of 0.9% in the first quarter. While there is no doubt that underlying growth has decelerated, data distortions have probably also contributed to the perceived slowdown. For instance, the dismal December retail sales report reduced the base for consumer spending going into 2019, thus shaving about 0.4 percentage points off Q1 growth. The drop in real personal consumption expenditures (PCE) cut the New York Fed’s Q1 growth estimate by a further 0.15 percentage points. We suspect that much of the weakness in December retail sales and PCE was linked to the government shutdown. The closure caused some of the surveys used to compile these reports to be postponed until January, which is historically the weakest month for retail sales. The Johnson Redbook Index – which covers 80% of the retail sales surveyed by the Department of Commerce – as well as the sales figures from Amazon and Walmart all point to strong spending during the holiday season (Chart 4). Chart 4The December U.S. Retail Sales Report Was Probably A Fluke The December U.S. Retail Sales Report Was Probably A Fluke The December U.S. Retail Sales Report Was Probably A Fluke Fundamentally, U.S. consumers are in good shape (Chart 5). As a share of disposable income, household debt is over 30 percentage points lower than it was in 2007. The savings rate stands at an elevated level, which gives households the wherewithal to increase spending. Job openings hit another record high, while wage growth continues to trend upwards. Fundamentally, U.S. consumers are in good shape. Chart 5U.S. Consumer Fundamentals Are Solid U.S. Consumer Fundamentals Are Solid U.S. Consumer Fundamentals Are Solid The housing market should improve. Rising mortgage rates weighed on housing last year. However, rates have been declining for several months now, which augurs well for home sales and construction over the next six months (Chart 6). Chart 6Mortgage Rates Will Not Be A Headwind For U.S. Housing Activity Over The Next 6 Months Mortgage Rates Will Not Be A Headwind For U.S. Housing Activity Over The Next 6 Months Mortgage Rates Will Not Be A Headwind For U.S. Housing Activity Over The Next 6 Months While capex intention surveys have come off their highs, they still point to reasonably solid expansion plans (Chart 7). Rising labor costs and high levels of capacity utilization will induce firms to invest in more capital equipment, which should support business spending. Chart 7U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Government expenditures should also recover. By most estimates, the shutdown shaved one percentage point from Q1 growth. This is likely to be completely reversed in the second quarter. The End Of The Chinese Deleveraging Campaign? The popular narrative about weaker Chinese growth has focused on the trade war. While trade uncertainty undoubtedly hurt growth last year – and has continued to weigh on growth so far this year – most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Fixed investment spending in China is generally financed through credit markets. Chart 8 shows that the contribution of investment spending to GDP growth has declined in tandem with decelerating credit growth.   Most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Chart 8China: Deleveraging Means Less Investment-Led Growth China: Deleveraging Means Less Investment-Led Growth China: Deleveraging Means Less Investment-Led Growth Chinese credit growth has typically reaccelerated whenever it has dipped towards trend nominal GDP growth. We may have already reached this point (Chart 9). New credit formation came in well above expectations in January. Given possible distortions caused by the timing of the Chinese lunar new year, investors should wait until the February data is released in mid-March before drawing any firm conclusions. Nevertheless, it is starting to look increasingly likely that credit growth has bottomed. The 6-month credit impulse has already surged (Chart 10). The 12-month impulse should also begin moving up provided that month-over-month credit growth simply maintains its recent trend (Chart 11). Chart 9Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Chart 10A Rebound In The Chinese 6-Month Credit Impulse A Rebound In The Chinese 6-Month Credit Impulse A Rebound In The Chinese 6-Month Credit Impulse Chart 11The 12-Month Impulse Is Set To Turn Up The 12-Month Impulse Is Set To Turn Up The 12-Month Impulse Is Set To Turn Up On the trade front, President Trump’s decision to delay the implementation of tariffs on $200 billion in Chinese imports is a step in the right direction. Nevertheless, gauging whether the trade war will continue to de-escalate is extraordinarily difficult. There is no major constituency within the Republican Party campaigning for protectionism. It ultimately boils down to what one man – Trump – wants. Our best guess is that President Trump will try to score a few political points by “declaring victory” – deservedly or not – in his battle with China in order to pivot to more pressing domestic issues such as immigration. However, there can be no assurance of this, which is why China’s leaders are likely to prioritize growth over deleveraging, at least for the time being. They know full well that the only way they can credibly threaten to walk away from the negotiating table is if their economy is humming along. Europe: From Headwinds To Tailwinds? Slower global growth, higher oil prices, and a spike in Italian bonds yields all contributed to the poor performance of the European economy last year. Economic activity was further hampered by a decline in German automobile production following the introduction of more stringent emission standards. The good news is that these headwinds are set to reverse course. Italian bond yields are well off their highs, as are oil prices (Chart 12). German automobile production is recovering (Chart 13). In addition, the European Commission expects the euro area fiscal thrust to reach 0.40% of GDP this year, up from 0.05% of GDP last year (Chart 14). This should add about half a percentage point to growth. Finally, if our expectation that Chinese growth will bottom out by mid-year proves correct, European exports should benefit. If neither the political establishment nor the general public favor Brexit, it will not happen. Chart 12Headwind No More (I): Italian Bond Yields Headwind No More (I): Italian Bond Yields Headwind No More (I): Italian Bond Yields Chart 13Headwind No More (II): German Auto Sector Headwind No More (II): German Auto Sector Headwind No More (II): German Auto Sector Chart 14The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Brexit still remains a risk, but a receding one. We have consistently argued that the political establishment on both sides of the British channel will not accept anything resembling a hard Brexit. As was the case with the EU treaty referendums involving Denmark and Ireland in the 1990s, the European political elites will insist on a “No fair! Let’s play again! Best two-out-of-three?” do-overs until they get the result they want. Theresa May’s efforts to cobble together a parliamentary majority that precludes a hard Brexit, along with the Labor Party’s increasing willingness to pursue a second vote, is consistent with our thesis. Fortunately for the “remain” side, public opinion is shifting in favor of staying in the EU (Chart 15). Focusing on the minutiae of various timetables, rules, and regulations is largely a waste of time. If neither the political establishment nor the general public favor Brexit, it will not happen. We are short EUR/GBP, a trade recommendation that has gained 5.2% since we initiated it. We continue to see upside for the pound. Chart 15The ''Remain'' Side Would Likely Win Another Referendum The ''Remain'' Side Would Likely Win Another Referendum The ''Remain'' Side Would Likely Win Another Referendum Investment Conclusions Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. The dollar is a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 16). The greenback will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Chart 16The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. We do not have a strong view on EM versus DM equities at the moment, but expect to shift EM to overweight once we see more confirmatory evidence that Chinese growth is stabilizing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. In conjunction with our expected upgrade on EM assets, we will move European equities to overweight. Stronger global growth will benefit European multinational exporters, while brisker domestic growth should allow the market to price in a few more ECB rate hikes starting in 2020. The latter will lead to a somewhat steeper yield curve which, along with rising demand for credit, should boost financial sector earnings (Chart 17). This will give European bank stocks a welcome boost. Chart 17Stronger Euro Area Credit Growth Will Boost Bank Earnings Stronger Euro Area Credit Growth Will Boost Bank Earnings Stronger Euro Area Credit Growth Will Boost Bank Earnings Japanese equities will also benefit from faster global growth, but domestic demand will suffer from the government’s ill-advised plan to raise the sales tax in October. As such, we do not anticipate upgrading Japanese stocks. We also expect the yen to come under some pressure as the BoJ is forced to maintain its ultra-accommodative monetary policy stance, while bond yields elsewhere move modestly higher.      Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com   Strategy & Market Trends* MacroQuant Model And Current Subjective Scores Chart 18 Tactical Trades Strategic Recommendations Closed Trades