アメリカ合衆国

Highlights Portfolio Strategy Depressed technicals, compelling valuations, macro tailwinds, improving operating fundamentals and the messages from our relative profit growth models and relative Cyclical Macro Indicators all signal that the time is ripe to initiate a long energy/short utilities pair trade. Pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Recent Changes Initiate a long S&P Energy/short S&P Utilities pair trade today. Table 1 Feature Equities propelled to uncharted territory, celebrating an easy Fed and the US/China détente with a hint of a tariff rollback, overcoming the seasonally difficult months of September and October. Historically, investors chase performance during the end of the year and seasonality will likely favor further flows into equities in the last two months of the year. On the economic front, while manufacturing remains in recession, a resilient labor market is providing a significant offset allaying fears of recession gripping the broad economy. Drilling deeper on the labor front is revealing. The unemployment rate ticked higher to 3.6% last month based on the household survey as the participation rate increased. However, according to the Sahm Rule Recession Indicator (SRRI), courtesy of Fed economist Claudia R. Sahm,1 were the unemployment rate to average 4% for three consecutive months by September 2020, the US economy will enter recession. In other words, based on empirical evidence the SRRI shows that when the three-month average unemployment rate has jumped by 50bps compared with previous twelve month low, the US has entered recession 100% of the time since the end of WWII (Chart 1). Chart 1Watch The Sahm Rule Recession Indicator Meanwhile, the parallels drawn with the mid-to-late 1990s and the current market backdrop have mushroomed, but our view is that the differences could not be wider. Since the history of our reconstructed SPX data going back to the late-1920s, there has never been a five-year period when the S&P 500 rose by at least 20% every year except for the 1995-1999 era. In that five-year period the SPX soared more than threefold, increasing annually by 34%, 20%, 31%, 27% and 20%, respectively. Investors forget that those were manic markets and despite a high and rising fed funds rate that peaked at 6.5% in early 2000 (real rates were over 4%), the forward P/E multiple went to the stratosphere ignoring theory and defying logic (Chart 2). Putting the late-1990s exuberance into perspective is instructive: if 1995 is similar to 2016 (and 1998 is similar to 2019) then the SPX should spike to over 6000 by the end of next year! Moving over to economic green shoots, we turn our attention to the signal the emerging markets are emitting. While both the EM and the Chinese manufacturing PMIs are expanding smartly, leading indicators suggest that the recovery may be running on empty. Chart 2One Of A Kind Chart 3Mixed Signals Chart 3 shows that the Chinese credit impulse is contracting, weighing on EM FX momentum and also signaling that the CAIXIN China manufacturing PMI, that has opened the widest gap with the official China NBS manufacturing PMI since the history of the data, will likely suffer a setback in the coming quarters. In the transportation sector, the Baltic Dry Index is down 33% since the early-September peak and is also losing steam on year-over-year basis, warning that a global trade recovery is skating on thin ice. Moreover, EM sentiment is downbeat. Investor flows into EM equities, according to the most liquid iShares MSCI EM ETF, have been drifting lower since the 2018 peak and have more recently gapped down (bottom panel, Chart 3). Thus, the recent green shoots may prove fleeting. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. With regard to US liquidity, that we have been inundated with client requests recently, we highlight our simple liquidity indicator: industrial production (IP) growth versus M2 money supply growth. In other words, we gauge how fast a unit of currency is translated into IP. Chart 4 highlights that IP/M2 is contracting at an accelerating pace, heralding further earnings growth pain for the S&P 500. US dollar based liquidity is also contracting as we showed in last week’s US Equity Strategy Webcast slides. Chart 4Clogged Pipelines Weighing On Profit Growth Other SPX profit indicators we track continue to suggest that the earnings soft patch is not out of the woods yet (we use forward EBITDA estimates to gauge trend growth, which excludes the one time fiscal easing boost to net EPS). Net forward EBITDA revisions are below zero, the ISM manufacturing new orders-to-inventories ratio has fallen 40% from the 2018 peak and is hovering near parity, momentum in the key ISM manufacturing new orders subcomponent is contracting and BCA’s boom/bust indicator continues to deflate. All of this, suggests that a turnaround in profits remains elusive and is a first half of 2020 outcome, at the earliest (Chart 5). Already, Q4/2019 profit growth estimates have now sunk into negative territory according to the latest FactSet data.2 Finally, the Fed released the last Senior Loan Officer Survey of the year in the past week and demand for C&I loans collapsed. This data series has broken below the 2016 trough and warns that C&I credit origination will continue to contract. Chart 5No Pulse Chart 6Capex Contraction Dampens Need For Credit Such a souring backdrop makes intuitive sense as animal spirits have died down courtesy of the Sino-American trade war. CEO’s are still voting with their feet and are canceling/postponing capital outlays. Absent capex, C&I credit demand runs aground (Chart 6). It remains unclear if a US/China “phase one” trade deal including tariff rollbacks can reverse the ongoing global trade contraction, signaling that caution is still warranted on the prospects of the broad equity market for the next 9-12 months. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. Long/Short Idea: Buy Energy/Sell Utilities There is an exploitable opportunity in going long the S&P energy sector/short the S&P utilities sector and we recommend initiating this market-neutral trade today. The top panel of Chart 7 shows that energy stocks have come full circle and are trading at levels last seen two decades ago when WTI oil was fetching less than half of today’s $55/bbl price. Encouragingly, there seems to be long-term support for relative share prices at the current overly depressed level. While utilities have been making headlines all year long given their outperformance, when put in proper perspective this niche defensive sector with a mere 3% weight in the SPX looks like a shipwreck (bottom panel, Chart 7). Taken together, this battle between two diminishing sectors presents a tradable opportunity by favoring energy stocks at the expense of utilities. In fact, this ratio trades at more than two standard deviations below the historical uptrend, and thus offers a lucrative risk/reward profile (Chart 8). Chart 7Buy Energy… Chart 8…At The Expense Of Utilities Beyond depressed technicals and compelling overall valuations with an alluring relative dividend yield (investors are paid an unprecedented 100bps in dividend yield carry to put on this trade, Chart 9), macro tailwinds, improving operating fundamentals, and the messages from our relative profit growth models and relative Cyclical Macro Indicators (CMI), all signal that the time is ripe to initiate a long energy/short utilities pair trade. On the macro front, inflation expectations have tentatively troughed and if oil rebounds further, as our Commodity & Energy Strategy service expects, then given their tight positive correlation with oil prices, rising inflation expectations should put a definitive floor under the relative share price ratio (Chart 10). Chart 9Unloved And Oversold Chart 10Return Of Inflation… However, the real interest rate component (i.e. growth) also explains roughly half of the selloff in the 10-year Treasury yield since early September, which also moves in lockstep with relative share price momentum (bottom panel, Chart 10). Were this budding global growth recovery to gain steam into the first half of 2020, then energy profits would outshine utility sector profits. As a reminder, oil is a global growth barometer and rises with increasing global growth while defensive utilities flourish when growth sputters (Chart 11). The US dollar’s recent appreciation has also dealt a blow to this trade and a grinding lower currency which is synonymous with a modest global growth recovery would also reverse this pair trade’s fortunes (top two panels, Chart 12). Chart 11…And Green Shoots Beneficiary Chart 12Operating Metrics Also… Zooming into the relative operating outlook, the bottom panel of Chart 12 shows that oil price inflation is outpacing natural gas selling prices. This relative underlying commodity backdrop is important as energy stocks move with the ebbs and flows of the oil market, whereas the marginal price setter for utility services is natural gas prices. The upshot is that heading into 2020, bombed out relative share prices should play catch up to the firming relative commodity backdrop. Capital spending outlays also favor energy shares over utilities stocks (top two panels, Chart 13). Surprisingly, the utilities sector net debt-to-EBITDA ratio is above 5x, waving a red flag, but energy indebtedness is coming down fast in the aftermath of the early 2016 oil price collapse and the energy sector’s net debt-to-EBITDA ratio is close to 2x (bottom panel, Chart 13). Our relative CMIs and relative profit growth models do an excellent job capturing all these moving parts and are unanimously sending a bullish message that an earnings-led recovery is in store for the relative share price ratio (Chart 14). Chart 13…Favor Energy Over Utilities Chart 14Green Light From US Equity Strategy Models Bottom Line: Initiate a long S&P energy/short S&P utilities pair trade today. Out Of Power Warning Utilities stocks have been all the rave this year, but given their small weighting in the SPX they only explain a very small part of the broad market’s run (in contrast, the heavyweight tech sector explains most of the S&P 500’s rise as we highlighted in recent research).3 We reiterate our underweight stance in this small defensive sector that has run way ahead of soft profit fundamentals. Worrisomely, utilities trade with a 20 forward P/E handle and command a 20% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 350bps (not shown). Chart 15 shows that our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession. Technicals are also extended (bottom panel, Chart 15), warning that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam.   Chart 15Overbought And Overvalued   In sum, pricey valuations, overbought technicals, the selloff in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. The top panel of Chart 16 shows that relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. Similarly, the recent selloff in the total return bond-to-stock ratio also warns that buying up expensive utilities at the current juncture is fraught with danger (second panel, Chart 16). The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (new export orders shown inverted, bottom panel, Chart 16). Chart 16Budding Recovery Weighing On Utilities Chart 17Sell The Strength Turning over to the sector’s operating metrics reveals that investors piling into utilities is unwarranted. Natural gas prices are contracting at the steepest pace of the past four years (middle panel, Chart 17) and signal that the path of least resistance is lower for relative share price momentum. Meanwhile, electricity capacity utilization is in a multi decade downtrend, warning that the relative profitability will remain under pressure in the coming quarters (bottom panel, Chart 17). In sum, pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Bottom Line: Shy away from the expensive S&P utilities sector. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     https://www.federalreserve.gov/econres/claudia-r-sahm.htm 2       https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q4-2019 3       Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights All the steps in the earnings dance are well known: Company management teams guide Wall Street analysts to lower their expectations in the weeks leading up to the beginning of earnings season, and their companies’ results then comfortably clear the lowered bar. Given the lack of true suspense, the S&P 500 largely ignores quarterly results: In the near term, moves in the S&P 500 have little to no relationship with either earnings growth or the magnitude of earnings beats. Over time, however, index prices and earnings move together: If earnings multiples mean-revert, earnings and prices have to converge over the long run. The equity bull market isn’t finished yet: The monetary policy backdrop will support earnings growth well into 2021, though it will not promote multiple expansion for much more than a year. Feature Chart 1We've Seen This Movie Before Taking a turn chairing BCA’s daily meeting last week, we duly updated our colleagues on the progress of earnings season. At the time, over 75% of the S&P 500’s constituents had reported, and the index was on its way to surpassing consensus analyst expectations by a few percentage points. We then showed charts tracking the course of expectations across each of this year’s three quarters to show that the “surprise” wasn’t actually very surprising (Chart 1). We included the charts to add a bit of levity, but a fellow strategist asked an incisive question: If earnings season follows the same pattern every quarter, why pay attention to it at all? Earnings season surely has its elements of Kabuki theater, but earnings are the fundamental basis for purchasing an ownership stake in a company. A share of stock is a claim on a company’s aggregate future earnings. To the extent that quarterly earnings reports provide a window into the trajectory of a company’s future earnings path, they contain relevant information about the fair value of its shares. Quarterly earnings offer more insight at the individual stock level than at the index level, as individual stocks are subject to idiosyncratic factors, while index earnings tend to reflect overall economic performance, and we therefore view them as a check on the other real-time indicators we examine to gauge the health of the economy. A review of how S&P 500 prices interact with S&P 500 earnings suggests that earnings have little to no impact on near-term index performance. They do move together in the long term, though, as they must if earnings multiples are a mean-reverting series. In the near term, when multiples are oscillating, anticipating stock market moves is a function of anticipating earnings growth and swings in multiples, which move independently of one another. The fed funds rate cycle has historically provided a good high-level guide to earnings and multiples trends. S&P 500 Performance During Earnings Season To test the S&P 500’s sensitivity to earnings surprises, we dug through weekly earnings updates going back to the beginning of 2012 (4Q11 earnings season) to compare expected index earnings per share (EPS) with reported index EPS.1 I/B/E/S has long been recognized as the earnings-estimates authority, so we use its estimates in conjunction with its compilation of reported earnings to ensure our analysis really is apples-for-apples.2 We track S&P 500 performance in three-month segments, beginning with the Monday following the second Friday of the new quarter, since that is the week that the banks typically get earnings season rolling. Earnings beats are stable and predictable, but the S&P 500's reaction to them is anything but. The empirical record over the last 31 quarters supports our colleague’s intuition. Over the 13 weeks following the major banks’ releases, S&P 500 performance exhibits no consistent link with earnings surprises (Chart 2). The best-fit line through a simple scatterplot shows that the relationship, such as it is, has been inverse and weak (Chart 3). The link with the year-over-year change in S&P 500 earnings is even weaker (Charts 4 and 5). Chart 2Earnings Surprises Don't Move The S&P 500 … Chart 3… Which Is Slightly Negatively Correlated With Them Chart 4Earnings Growth Doesn't Move The S&P 500 … Chart 5… Which Has No Short-Term Relationship With It Earnings data support our colleague’s contention that earnings season, at least as it relates to expectations, is something of a charade. Companies, which heavily influence analyst estimates with their guidance, have beaten expectations every quarter for at least eight years. As Charts 2 and 3 show, earnings beat expectations by an average of 3.7%, nearly the midpoint of the 1-6% range. The S&P 500 shouldn’t be expected to react to “surprises” that are more or less pre-ordained. Bottom Line: Earnings season has no observable impact on the S&P 500. Earnings attract a lot of attention, but they do not influence index-level performance in the near term. The S&P 500 And Earnings Over Longer Periods Anything can happen over short periods, but stock prices have to track earnings over the long term. If the idea that an ownership share represents a proportional stake in company earnings is too abstract, consider the equity equation. Equity prices, P, can be viewed as the product of earnings, E, and the multiple investors are willing to pay for each dollar of earnings, P/E. P = E * (P/E) The market P/E ratio is subject to mean reversion, making changes in earnings the key long-term driver of S&P 500 performance. Since 1966, the S&P 500 index (Chart 6, top panel) has appreciated at the same rate as its trailing four-quarter operating earnings (Chart 6, middle panel), given that its trailing multiple is not far from where it started (Chart 6, bottom panel). Growth in forward earnings expectations (Chart 7, middle panel) has lagged S&P 500 growth (Chart 7, top panel) since expectations data began to be compiled in 1979 because the forward multiple has more than doubled from late ‘70s trough levels (Chart 7, bottom panel). In any extended period not bookended by an outlier multiple, however, one should expect S&P 500 appreciation to track earnings estimate growth. Chart 6S&P 500 Earnings And Prices Will Converge Over Time ... Chart 7... As Long As The Starting Or Ending Multiple Isn't An Outlier Bottom Line: Stock price gains and earnings growth will converge over the long run as long as the earnings multiple mean-reverts. Earnings do matter in the long run. Where Do We Go From Here? There are several earnings growth models within BCA. Like all regression models, they often work well in stretches, but are susceptible to unanticipated inflections and changes in correlations. Since the crisis, the difference between year-over-year growth in industrial production and year-over-year growth in the money supply has aligned closely with earnings growth (Chart 8). If we (and global equity markets) are correct in sniffing out a bottoming in global manufacturing activity, and loan growth is unlikely to accelerate much as banks are pulling in their horns in commercial real estate and selected consumer categories, earnings growth could pull out of its funk. Chart 8Earnings Growth Will Revive Once Global Manufacturing Pressure Abates We have found that earnings growth and multiple re-rating or de-rating is reliably influenced by the monetary policy backdrop. While the level of the fed funds rate goes a long way to explaining overall index moves, earnings growth and multiple expansion/compression are a function of its direction. Broadly, forward estimates grow at a rapid rate when the Fed is hiking rates (the economy is expanding) and slump when it’s cutting them (the economy needs a hand). Forward multiples are the mirror image of earnings estimates, contracting when the Fed is hiking and expanding at a robust clip when the Fed is cutting. Earnings grow at a rapid clip when the Fed is leaning against a too-strong economy, but they slump when the Fed is trying to nurse it back to health. Viewed through the lens of the fed funds rate cycle (Figure 1), policy had been in Phase I from December 2015, when the Fed began hiking rates, until the end of July, when the Fed began cutting, transitioning into Phase IV. Phase IV has been characterized by solid multiple expansion and, ex-2008-9, decent earnings growth. It will remain in force until the Fed returns to hiking rates, which we do not expect until the second half of 2020 at the earliest. Once the Fed does resume hiking, it will likely take some time for it to raise the fed funds rate above its equilibrium level (Phase II). Figure 1The Fed Funds Rate Cycle Our base case is that the Fed will not turn restrictive until 2021. Easy monetary policy is a tailwind for earnings growth, which remains strong in Phase II, so we expect that earnings growth will shake loose of 2019’s doldrums across the next two years. Stocks should benefit from re-rating until the Fed resumes hiking rates (Phase I), cutting off multiple expansion. They will de-rate once monetary policy becomes restrictive (Phase II), as it must once the Fed perceives a need to cool the economy. The bottom line is that the monetary policy backdrop should be earnings-friendly well into 2021, even if multiple expansion isn’t likely to persist beyond the next nine to twelve months. Investment Implications Investors should not look to quarterly earnings reports to inform asset allocation decisions. Quarterly releases may be telling for individual companies’ longer-run profit potential, but they do not shed much light on the S&P 500’s future earnings. The long-run index earnings profile is much more likely to be influenced by broad themes than real-time data points. We devote our focus to the cyclical forces affecting asset-class-level returns, and find that the monetary policy cycle offers useful insight into future moves in earnings and multiples. The Fed's dovish pivot will help keep the expansion going, ... That insight is favorable for equities, and for spread product as well. We are in the latter stages of both the business cycle and the credit cycle, but new injections of monetary accommodation and the postponement of the shift to restrictive monetary policy settings will extend the longevity of the expansion and the period over which credit generates positive excess returns. Investors have different objectives and risk tolerances, but we think all of them should remain at least equal weight equities in balanced portfolios, and overweight spread product (and underweight Treasuries) within fixed-income sleeves. It is too soon to de-risk investment portfolios.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 All data cited in this section comes from Refinitiv’s (formerly Thomson Reuters’) This Week in Earnings publication. 2 Earnings estimates compiled by other vendors may differ from I/B/E/S estimates, and other measures of reported earnings, like Standard & Poor’s, regularly diverge from I/B/E/S’.

特別レポート

Highlights Maintaining an adequate level of aggregate demand has proven to be one of the biggest macroeconomic challenges of the modern era. Yet, in principle, it should not be difficult to increase demand. After all, people like to consume. If households are not spending enough, governments can just give them money or increase spending directly on public infrastructure and other worthwhile endeavors.  Various explanations have been proposed for why these solutions either won’t work or are bad ideas even if they do work. These include Ricardian Equivalence-type arguments; claims that periods of high unemployment may be necessary to cleanse financial and economic imbalances; and concerns about excessive levels of government debt. None of these explanations are particularly persuasive, which suggests that politics, rather than economics, may be at the heart of the demand-side secular stagnation problem. Bondholders benefit from low inflation, which has often led them to oppose meaningful fiscal stimulus. Looking out, the influence of bondholders is likely to wane as populism proliferates. Investors should favor “real assets” such as equities, real estate, and commodities over “nominal assets” such as bonds and cash. A Rather Peculiar Problem Some problems are hard to solve. Curing cancer is hard. Reconciling quantum mechanics with general relativity is hard. But why should getting people to spend more be so difficult? After all, people like to consume. It is getting them to save that should be challenging. And yet, the most pressing macroeconomic problem in many countries over the past decade (and much longer in Japan) has been generating enough spending to achieve full employment, which is a precondition for allowing central banks to move away from extreme measures such as quantitative easing and negative rates. It would be one thing if secular stagnation were primarily a problem of inadequate supply. Increasing supply is difficult. While some economists such as Robert Gordon have focused on the poor prospects for potential GDP growth in developed economies (sluggish productivity and labor force growth being among the key culprits), the Larry Summers characterization of secular stagnation is first and foremost about inadequate demand. If people are not spending enough, why can’t the government simply increase transfers to households or spend money directly on public infrastructure, scientific exploration, or other worthwhile endeavors? Three arguments have been advanced as to why this strategy either will not work or is a bad idea even if it does work: 1) Ricardian Equivalence-type theories claiming that the private sector will increase savings by enough to counter larger budget deficits, thus leaving overall demand unchanged; 2) claims that periods of high unemployment are both necessary and desirable for shifting resources to more productive uses; and 3) concerns that higher government debt levels stemming from larger budget deficits will impose long-term costs that swamp the short-term growth benefits of fiscal stimulus. As we discuss below, none of these arguments are particularly persuasive. This suggests that politics, rather than economics, explains why there has been so much reluctance towards fiscal easing. Ricardian Equivalence Ricardian Equivalence stipulates that the lifetime present value of after-tax income determines household consumption. This implies that if a government issues each person a check for $1 million, everybody will just save the money in anticipation of higher taxes down the road. If that sounds a tad implausible, this is because the theory assumes, among other things, that everyone is perfectly rational, can borrow as much as they want, and lives forever (or at least values their heirs’ or beneficiaries’ welfare as much as their own).  The theory is even less convincing when applied to government spending. Only in the extreme scenario where the government permanently increases spending would rational, infinitely-lived households cut their spending by exactly enough to offset the rise in government expenditures. If the increase in government spending were perceived to be temporary, aggregate demand would still rise, even if everyone is completely rational. To see this, consider a case where the government increases spending by $1 billion per year for three years. The “rational” response would be for households to cut their own expenditures by the annual carrying cost of the additional $3 billion in debt. Assuming an interest rate of 2%, this would amount to a reduction in annual consumption of about $60 million, leaving a net annual fiscal boost of $940 billion. The example above almost certainly overstates the negative impact on consumption in situations where the economy is operating below potential. This is because raising government spending in a depressed economy will boost output, thus increasing the present value of lifetime incomes. The expectation of higher income will lift consumption. The bottom line is that Ricardian Equivalence applies only in a very narrow range of circumstances, none of which are relevant in the real world. Indeed, as Box 1 discusses, the empirical evidence clearly suggests that fiscal multipliers are positive, especially in economies grappling with high unemployment. The Urge To Purge One popular view, often associated with the Austrian School of economics, is that recessions cleanse the economy and the financial system of excesses, paving the way for faster growth. The main problem with this view is that it assumes that resources will only shift to more worthwhile uses if many people are unemployed. In practice, this is not the case. In any given month, about five million US workers will either quit or lose their job, while a slightly higher number will find new work (Chart 1). Chart 1Labor Market Churn Tends To Increase As Unemployment Falls Chart 2Residential Construction Accounted For Only 20% Of The Job Losses During The Great Recession   The small difference between gross inflows and outflows is the net change in employment. This is the number investors focus on every month when the payroll report is released; it is usually less than 5% of gross flows. Strikingly, gross separations usually rise when the unemployment rate falls, implying that labor market churn increases when the economy strengthens. This occurs because more people tend to quit their jobs when the labor market is tight and job openings are plentiful. The pro-cyclicality of the quits rate dominates the counter-cyclicality of the discharge rate. The Great Recession demonstrated that most of the job losses during severe downturns are gratuitous in the sense that they impose needless suffering on workers without making the economy more productive. Chart 2 shows that only 20% of US job losses between 2007 and 2009 took place in the residential building sector and related financial activities where excesses were plainly evident. The rest of the losses were in parts of the economy that had little to do with the housing bubble.   Too Much Debt? Opponents of loose fiscal policy often point to rising government debt levels as an unwelcome side effect of larger budget deficits. Worries about high debt levels are certainly justified for countries that do not print their own currencies. When a country lacks a buyer of last resort for its debt, a self-fulfilling crisis can develop where rising bond yields make it more difficult for the government to service its obligations, leading to even higher bond yields (Chart 3). Chart 3Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort In contrast, central banks in countries that are able to issue debt in their own currencies can always purchase their own government’s bonds with newly issued cash. They can also set short-term interest rates at whatever level they want, thus ensuring that the government has a reliable source of financing. The “golden rule” for debt sustainability says that a country’s debt-to-GDP ratio will stabilize as long as the interest rate the government pays on its debt is less than the growth rate of the economy. This is true regardless of how big a primary budget deficit the government runs (Chart 4).1 Chart 4Debt Dynamics When r Is Less Than g In fact, the higher the debt-to-GDP ratio is, the larger the sustainable level of the budget deficit that the government can achieve. For example, if nominal GDP growth is 4% and the target debt-to-GDP ratio is 50%, the government can run a budget deficit of 2% of GDP in perpetuity; in contrast, if the target debt-to-GDP ratio is 250%, the government can run a budget deficit of 10% of GDP. The catch is that this magic only works if the interest rate stays below the growth rate of the economy. When there is a lot of spare capacity, this is not a major issue since interest rates can be kept low without the worry that inflation will accelerate. Things get trickier once the economy reaches full employment. At that point, if the budget deficit remains high, inflation could rise as aggregate demand begins to outstrip the economy’s productive capacity. This may cause the central bank to raise interest rates, which could be a vexing problem for a highly indebted government. One might argue that the government could preempt the central bank from having to raise rates simply by tightening fiscal policy once the economy begins to overheat. In many cases, this would indeed be the correct response. However, there may be some occasions where tightening fiscal policy is politically impossible. In such cases, the preferred political response may be to allow inflation to rise. Higher inflation would push up nominal income, thus putting downward pressure on the debt-to-GDP ratio. Once the real value of the debt has been inflated away, the central bank could raise rates in order to cool the economy. Would such an inflationary strategy be preferable to not running a large budget deficit to begin with? It depends on who you ask! If you ask bondholders, they would certainly say no. If anything, bondholders might prefer a deflationary environment since falling prices would increase the purchasing power of their bonds. In contrast, workers and businesses may prefer more stimulus. For them, higher inflation down the road is a price worth paying if it means continued low unemployment and rising profits. How do these competing interests balance out? In most cases, the economy would be better off following the bigger budget deficit/higher inflation strategy. This is partly because deflation is generally a greater risk to the financial system and the broader economy than inflation. It is also because the capital stock is likely to grow more quickly in an economy that is able to stay close to full employment than one that suffers from deficient demand (firms generally invest more when unemployment is low). Hence, not only can fiscal stimulus provide short-term support to employment and consumption during the period when demand is depressed, it can even generate longer-term gains in the form of higher labor productivity and lower structural unemployment compared to what would have happened in the absence of any fiscal easing. The Political Economy Of Debt And Inflation The discussion above suggests that political forces, rather than economic logic, explain why some countries fail to take the necessary steps to solve what should be an elementary problem: increasing demand. In particular, demand-side secular stagnation is likely to be a bigger threat in countries where the preferences of bondholders and others who benefit from very low inflation hold sway. The appreciation of this fact helps explain some key developments in economic history, while shedding light on what the future may hold. Chart 5Universal Suffrage Made Inflation Politically More Palatable Than Deflation The introduction of universal suffrage in the first few decades of the twentieth century made inflation politically more palatable (Chart 5). A poor farmer did not need to worry quite as much about losing his land to the bank, since he could vote for someone who would ensure that crop prices increased rather than decreased. In William Jennings Bryan's colorful words, the rich and powerful would no longer “crucify mankind upon a cross of gold." Today, populism is on the rise again. Whether it is rightwing populism or leftwing populism, the result is usually the same: bigger budget deficits and higher inflation. Retirees may not welcome higher inflation, but given the choice between rising prices and cuts to pensions and health care programs, they are likely to opt for the former. For their part, today’s youth has become increasingly enamored with socialism. According to a recent YouGov poll, 70% of Millennials would be somewhat or extremely likely to vote for a socialist candidate (Chart 6). More than one-third of Millennials view communism favorably, while about 20% think the Communist Manifesto “better guarantees freedom and equality” than the Declaration of Independence. No wonder the Democrats are talking about introducing Universal Basic Income, Medicare For All, and a Green New Deal. Chart 6Woke Millennials Cozying Up To Socialism Contrary to conventional wisdom, an individual’s political attitudes are fairly stable over their lifespan.2 This suggests that the average political orientation of US voters will continue to move leftward as older voters pass away. Meanwhile, globalization – a historically deflationary force – has peaked (Chart 7). And despite all the hype about game-changing technological innovation, productivity growth in advanced economies continues to underwhelm (Chart 8). Chart 7Globalization Has Peaked   In a world of excess savings, inflation could be held at bay. However, the ratio of workers-to-consumers has now begun to decline as ever more baby boomers leave the labor force (Chart 9). As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. Chart 8Productivity Growth In Advanced Economies Has Decelerated Materially Chart 9The Worker-To-Consumer Ratio Has Peaked Globally   Investment Conclusions Few people are worried about rising inflation these days, as evidenced by the weakness in long-term market-based inflation expectations (Chart 10). For now, most of our leading inflation indicators remain contained (Chart 11). However, we suspect this will change in the next few years as the unemployment rate – which is already at a generational low in the G7 – continues to fall (Chart 12). Chart 10Long-Term Inflation Expectations Are Muted Chart 11An Inflation Breakout Is Not Imminent   Chart 12Falling Unemployment Rate Across Developed Markets Chart 13Prices And Wages In Japan Have Been Rising Since 2014... Albeit At A Sluggish Pace   Chart 14Japan: Labor Market Tightening May Eventually Spur Higher Inflation As we discussed two weeks ago in our analysis of whether negative rates will spread out across the world, both the theoretical and empirical evidence suggest that the Phillips curve is kinked.3 This means that a decline in the unemployment rate may not have a significant effect on inflation until unemployment reaches a threshold that is low enough to trigger a price-wage spiral. The US will probably be the first major economy to reach the kink, but others will follow. This includes the mother of all recent deflationary economies: Japan. Chart 13 shows that Japanese prices are rising again, albeit still at a slower pace than the BoJ’s target. Japanese inflation will accelerate if the labor market continues to tighten. Already, the ratio of job openings-to-applicants is near a 45-year high (Chart 14). All this suggests that investors should favor “real assets” such as equities, real estate, and commodities over “nominal assets” such as bonds and cash. To the extent that investors need to maintain exposure to fixed income, we would recommend a short-duration stance and above-benchmark exposure to inflation-linked securities. Box 1 Fiscal Multipliers: How Large? Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 2Johnathan Peterson, Kevin Smith, and John Hibbing, “Do People Really Become More Conservative as They Age? ” The Journal of Politics, (2018). 3Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” dated October 25, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights The correlation between oil and petrocurrencies has shifted in recent years. It no longer makes sense going long petrocurrencies versus the US dollar blindly. One of the reasons has been the impressive and prominent output from US shale. We are currently long a basket of petrocurrencies versus the euro, but intend to shift this trade towards a short USD position on more visible signs of a breakdown in the US dollar. Go short CAD/NOK for a trade. Feature Chart I-1Oil And Petrocurrencies Have Diverged Since the middle of the last decade, one of the most perplexing disconnects has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices more than doubled, but the petrocurrency basket has underperformed by a whopping 110% versus the US dollar. This has been a very perplexing result that has surprised many investors on what was traditionally a very sound correlation (Chart I-1).  In general, an increase in oil prices usually implies rising terms of trade, which should increase the fair value of a currency. Throughout our modeling exercises, terms of trade were uncovered as what mattered the most for commodity currencies in general, and petrocurrencies in particular. In theory, this makes sense, given the improvement in balance-of-payment dynamics (that tend to be observed with a lag) and the ability for increased government spending, allowing a resident central bank to tighten monetary policy. In the case of Canada and Norway, petroleum represents over 20% and 50% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast, but it has now become a necessary but not sufficient condition. Oil Demand Should Recover We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt (Chart I-2). Chart I-2Oil Demand Has Been Weak Part of the slowdown in global demand is being reflected through elevated inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-3). Chinese oil imports continue to hold up well, and should easier financial conditions put a floor on the manufacturing cycle, overall consumption will follow suit (Chart I-4). Chart I-3Oil Inventories Are Elevated Chart I-4China Oil Imports Holding Up The increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity is only at 2%. This means that any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints – especially in the face of OPEC production discipline. Second, unplanned outages wiped out about 1.5% of supply in 2018, and should this occur again as oil demand recovers, it will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-5Opec Spare Capacity Is Low Bottom Line: A recovery in the global manufacturing sector will help revive oil demand. This should be positive for oil prices in general. A Necessary But Not Sufficient Condition Rising oil prices are bullish for petrocurrencies, but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. As the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-6). Chart I-6US Has Grabbed Oil Production Market Share This explains why the positive correlation between petrocurrencies and oil has been gradually eroded as the US economy has become less and less of an oil importer. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Meanwhile, falling production in Iran, Venezuela, and even Angola has been a net boon for US production and the dollar.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-7). Since then, that correlation has fallen from around 0.9 to around 0.2. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the US becomes a net energy exporter. Chart I-7Falling Correlation Between Petrocurrencies And The US Dollar Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Oil Consumers Versus Producers Our strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar downleg. We are long an oil currency basket versus the euro, but intend to make the switch once our momentum indicators for the dollar decisively break lower. With bond yields having already made a powerful downward adjustment, the valve for financial conditions to get any looser could easily be via the US dollar (Chart I-8). A loss of global market share has hurt the oil sensitivity of many petrocurrencies. The second strategy is to be long a basket of oil producers versus oil consumers. Chart I-9 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. It is also notable that the correlation has strengthened as that between petrocurrencies and the US dollar has weakened. Chart I-8The Dollar As An Arbiter Of Growth Chart I-9Buy Oil Producers Versus Oil Consumers Sell CAD/NOK The Norges Bank has been quite hawkish in spite of the dovish tilt by most other central banks. As such, the underperformance of the Norwegian krone, especially versus the euro, has been quite perplexing in the face of diverging monetary policies (Chart I-10). Our bias is that speculators have been using the thinly traded krone to play USD upside, but that momentum is now fading. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence, and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. A weak exchange rate will also anchor inflation expectations (Chart I-11). Chart I-10Diverging Monetary ##br##Policies Chart I-11A Weak Exchange Rate Will Anchor Inflation Expectations Higher The underperformance of the Norwegian krone has mirrored that of global oil and gas stocks. Perhaps sentiment towards the environment and climate change has been pushing investor flows out of these markets, but given the central role oil plays in the global economy, we may have reached the point of capitulation (Chart I-12). Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts. Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-13). The CAD/NOK briefly punched through the 7.1 level in October but is now seeing a powerful reversal. Our intermediate-term indicators also suggest the next move is likely lower. The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart I-14) Chart I-12ESG And Global Divestments Chart I-13NOK Will Outperform CAD (I) Chart I-14NOK Will Outperform CAD (II) Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been strong:  The labor market remains tight: nonfarm payrolls increased by 128K in October, well above expectations of 89K. Average hourly earnings continue to grow by 3% year-on-year. Unit labor costs grew by 3.6% year-on-year in Q3. The ISM manufacturing PMI increased to 48.3 from 47.8 in October. The non-manufacturing PMI soared to 54.7 from 52.6 in October, well above expectations. The trade balance narrowed by $2.5 billion to $52.5 billion in September. The DXY index appreciated by 0.8% this week. ISM PMI data points to improvements in both manufacturing and services sectors, mainly supported by production, new orders, and the employment components. It will be interesting to monitor if this signals an improvement in the global manufacturing cycle, or is a US-centric issue. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Markit manufacturing PMI slightly increased to 45.9 from 45.7 in October. The services PMI also improved to 52.2 from 51.8. The Sentix confidence index increased to -4.5 from -16.8 in November.  Retail sales grew by 3.1% year-on-year in September, an improvement from the 2.7% yearly growth rate in the previous month. EUR/USD fell by 0.8% this week. On Monday, Christine Lagarde, the former managing director of the IMF, gave her first speech as the new ECB president where she urged Europe to overcome self-doubt, aiming to boost investor and business confidence in the euro area. However, no comments were given regarding ECB monetary policy. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Vehicle sales shrank by 26.4% year-on-year in October. The monetary base grew by 3.1% year-on-year in October. The services PMI plunged to 49.7 from 52.8 in October. The Japanese yen depreciated by 1% against the US dollar this week. We remain short USD/JPY given global economic uncertainties and domestic deflationary tailwinds. Should the global economy pick up early next year, the yen could still remain bid against the USD, allowing investors time to rotate their short USD/JPY bets. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 49.6 from 48.3 in October. Services PMI increased to 50 from 49.5 in October. Retail sales increased by 0.1% year-on-year in October, compared to a contraction of 1.7% in the previous month. Halifax house prices grew by 0.9% year-on-year in October. GBP/USD depreciated by 1% this week. On Thursday, the BoE decided to leave its interest rate unchanged at the current level of 0.75%. However, unlike a unanimous decision as in previous policy meetings this year, two BoE officials unexpectedly voted to lower interest rates amid signs of deeper economic slowdown and entrenched Brexit chaos. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Retail sales grew modestly by 0.2% month-on-month in September. The Commonwealth composite PMI fell slightly to 50 from 50.7 in October. The services PMI also fell to 50.1 from 50.8. The trade balance increased by A$1.3 billion to A$7.2 billion in September. Both exports and imports grew by 3% month-on-month in September. The Australian dollar has been volatile against the US dollar, but returned flat this week. The RBA has left its interest rate unchanged this Monday, as widely expected. We remain positive on the Australian dollar and went long AUD/CAD last week, which is currently 0.3% in the money. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The participation rate increased marginally to 70.4% from a downward-revised 70.3% in Q3. The labor cost index increased by 2.3% year-on-year in Q3. The unemployment rate however, climbed to 4.2% from 3.9%, higher than expectations of a rise to 4.1%. The kiwi fell by 1.4% against the US dollar, making it the worst performing G-10 currency this week. Despite the rise of the unemployment rate in Q3, the under-utilization rate, a broad measure of labor market spare capacity has fallen to the lowest level in over 11 years, as suggested by the manager of Statistics New Zealand, Paul Pascoe. That said, we remain underweight the kiwi given it will likely lag other commodity currencies in a global growth upswing. We will change this view if New Zealand terms of trade start to inflect meaningfully higher. Stay with our long AUD/NZD and SEK/NZD positions. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI was little changed at 51.2 in October. The trade deficit narrowed marginally from C$1.24 billion to C$0.98 billion in September. Exports and imports both fell in September. Ivey PMI fell to 48.2 from 48.7 in October. USD/CAD increased by 0.3% this week. The recent uptick in oil prices support the Canadian dollar, but the loonie will likely underperform other petrocurrencies. We remain bullish on the oil prices, however, spreads will likely continue to move against the Western Canadian Select blend. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline CPI fell below 0 at -0.3% year-on-year for the first time over the past 3 years in October. On a month-on-month basis, it contracted by 0.2%. Real retail sales grew by 0.9% year-on-year in September. PMI improved to 49.4 from 44.6 in October. FX reserves were little changed at CHF 779 billion in October. The Swiss franc fell by 0.9% against the US dollar this week. Faced with deflationary pressures, the SNB will likely to use its currency as a weapon to stimulate the economy and exit deflation. This will favor long EUR/CHF positions. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Industrial production contracted by 8.1% year-on-year in September, mainly caused by the slowdown in extraction and related services. On the positive side, manufacturing output grew by 2.9% year-on-year. The manufacturing output of ships, boats, and oil platforms in particular, grew by 26.2% year-on-year in September. The Norwegian krone appreciated by 0.3% against the US dollar this week, despite the broad dollar strength. The WTI crude oil price increased by nearly 6% this week, which is a tailwind for petrocurrencies. We maintain a pro-cyclical stance and expect oil prices to increase further. The global growth recovery and a weaker US dollar should all boost the oil demand, and lift the Norwegian krone. Please refer to our front section this week for more detailed analysis on the NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The manufacturing PMI fell marginally to 46 from 46.3 in October. Industrial production growth slowed to 0.9% from 2.1% year-on-year in September. Manufacturing new orders contracted by 1.5% year-on-year in September. The Swedish krona has been flat against the USD this week. The PMI components of new orders, industrial production, and employment all continued to fall. On the positive side, the export component increased marginally. We expect the cheap krona to help improve the trade dynamics in Sweden and put a floor under the krona. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

The latest NFIB job openings data nosedived, warning that small cap troubles are even deeper than previously assumed. Worrisomely, when compared with non-farm payrolls (gauging the large cap labor market) our proxy is sending an unambiguously negative signal that relative earnings growth will remain downbeat in the coming quarters (middle panel). Already, forward profit estimates are sinking like a stone for small cap indexes, but large caps have remained resilient (bottom panel). Tack on the relative indebtedness of small versus large caps (not shown) and we continue to recommend a large cap size bias.  

Highlights Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – are experiencing mass unrest. Protesters in both states are calling for the dismantling of sectarian based political systems, economic reforms, and reduced foreign interference. The unrest in Iraq is of greater consequence due to its role as a major global oil supplier. The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary.  We remain tactically long spot crude oil on the back of the geopolitical risks to supply amid an expected revival in global demand. Feature A wave of popular uprisings has swept over Lebanon and Iraq. While the riots are to a large extent a product of long-standing economic and governance failures, the timing is consequential. The Middle East is experiencing a paradigm shift. With the US reducing its strategic commitment to the region, most recently evidenced by the withdrawal of its troops from northeast Syria, a power vacuum has emerged. This opens up the necessity for foreign actors – Russia – as well as regional powers – Saudi Arabia, Iran, and Turkey – to fill the void. The evolution of power could be unsettling given that it will likely generate greater instability in a region that is fertile ground for unrest. Iran has so far emerged a winner in this dynamic. It has expanded its influence in Iraq since the US pullout, it has played a critical role in saving the Assad regime, and it has seen Saudi initiatives fail in Syria, Yemen, Lebanon, and Qatar. It is making progress toward building its ‘land bridge’ to the Mediterranean (Map 1).1 Map 1Iran’s Aspirational ‘Land Bridge’ To The Mediterranean The tensions brought about by the US withdrawal from the JCPOA further illustrate Iran’s growing regional sway. It has hardened its stance. Meanwhile the US and its allies have been vacillating. The Saudi coalition – mired in a war in Yemen and confronting domestic risks – is reluctant to engage in a full-scale confrontation.  Even though Iran has a higher pain threshold, it stands on shaky ground. Just last year it was rocked by domestic protests demanding less foreign adventurism. Lebanon and Iraq are the two countries most entrenched in Iran’s sphere of influence. Protesters in both countries are calling for greater national unity – demanding an overhaul of the political system, and arguing that the sectarian set-up has failed to meet their most basic needs. What occurs in Beirut and Baghdad will be of great consequence for Tehran. Deadlock In Iraq “Out, out, Iran! Baghdad will stay free!” - Chants by Iraqi protesters While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.2 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Chart 1AFertile Ground For Unrest In Iraq The protesters are also united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 1A & 1B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 1BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Where the election results failed to translate into real change for Iraq is in the appointment of the Prime Minister. Abdul-Mahdi – a technocrat – was a compromise candidate that surfaced as a result of a five-month long political standstill between the two rival Shia blocs, each claiming to have gained a majority of seats in parliament. On one end is the Iran-backed bloc led by Hadi al-Amiri head of both the Fatah Alliance and the PMF, and Nouri al-Maliki leader of the State of Law Coalition. On the other end is al-Sadr’s Sairoon coalition, which joined forces with Ammar al-Hakim of the Wisdom Movement, and champions greater unity and less foreign interference. The result has been a weak prime minister who is perceived to be incapable of pushing back against Iraq’s ruling elites and ushering in structural reforms. Instead the Prime Minister is seen as benefiting from a corrupt system. The rift between Iraq’s rival Shia blocks is deepening. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs. Last week Abdul–Mahdi responded to calls by al-Sadr and former Prime Minister Haider al-Abadi to resign by arguing that it is up to the main political leaders to agree to put forward a vote of no confidence in the Iraqi parliament. He agreed to resign, on condition that political parties jointly approve of a replacement. For now, that appears improbable. In a move that has been interpreted as a display of Iranian interference, al-Amiri changed heart after a reported meeting with Iranian Quds Force leader Qassem Suleimani last week in Baghdad. He backed down on his agreement to support al-Sadr to bring down Abdul-Mahdi, and has instead stated Abdul-Mahdi’s resignation will only bring about more chaos. This interference on the part of Iran was likely induced by fears that a crisis-stricken Iraq would weaken its hegemony over the region. Iraq is in a state of deadlock. A vote of no confidence would require a majority of 165 in parliament and would require the support of various Sunni and Kurdish parties (Chart 2). Al-Sadr is likely calculating that a new election is in his best interest. He would be able to capitalize on the movement given that he has aligned himself with the protesters, and will gain seats in parliament. Chart 2A Shia Schism In Iraq’s Parliament This would allow the nationalist bloc to gain a majority and appoint a government that is acceptable to the protesters. However, this scenario would also entail greater meddling from Iran, as it is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.3 Despite the death of over 260 Iraqis, the protesters have yet to be deterred by the violence. This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. The impasse could be resolved if the main actors – the rival Shia blocs – agree to compromise. However, that is precisely what transpired last year and resulted in Abdul-Mahdi’s appointment. It ultimately led to only a temporary resolution of the unrest: a one-year deferral. If a similar compromise is reached in the current environment, it too will result in only a temporary détente. The grievances afflicting Iraqis cannot be resolved easily or swiftly. Iraq is in for an extended period of instability. Bottom Line: Iraqi protesters and authorities are in stalemate. The rift in the Shia bloc is deepening. There does not appear to be a clear path to bridge the demands and desires of the protesters and the leadership. Any détente will be temporary. Even if under a new election the protests translate to greater seats for the nationalist bloc, it will not translate to a de-escalation of domestic tensions. It may resolve the protests, but Iran-backed groups will retaliate. Iraq is in for an extended period of instability. Deadlock In Lebanon “All of them means all of them” “No to Iran – No to Saudi” - Chants by Lebanese protesters Just as Iraqi protesters are expressing national unity in calling for an end to sectarian politics and foreign interference, Lebanon’s protests stand out for crossing religious and regional divides. They have swept across the country, and include the Shia-dominated southern region where anger is even being directed at Hezbollah. Among the protesters’ demands is the removal of all three heads of the pillars of government – the Maronite Christian President Michel Aoun, the Sunni Prime Minister Saad Hariri, and the Shia Speaker of Parliament Nabih Berri. Rather than being a source of division, the unrest is a demonstration of unity among Lebanese of all ideologies against the entire political system. Since Prime Minister Saad Hariri’s resignation on October 29, the movement rages on. Protesters are claiming that they are unwilling to back down until all their demands are met, including a complete overhaul of the sectarian power-sharing system, which has defined the country’s politics since the end of the 1975-1990 civil war.4 Chart 3Economic Deterioration In Lebanon The movement and the protesters’ complaints are not surprising. The government has failed to prevent the economy from moving toward collapse. It has long been in decline, with Lebanese feeling the pinch of corruption, economic stagnation, high unemployment, and the effects of the massive influx of Syrian refugees (Chart 3).The trigger of the uprising, a tax on WhatsApp calls amid clear signs of a domestic liquidity shortage, is a delayed response to what citizens have already known and felt for some time: a deteriorating economic situation. While the protests were caused by these economic grievances, they persist due to a crisis of confidence between the political class and the masses. Neither concessions on the part of the government in the form of a list of reforms nor the prime minister’s resignation convinced protesters to halt the movement. The uprising appears set to remain steadfast so long as the current politicians remain in power. The challenge for Lebanon’s protesters – and political elite all the same – is that while the protesters are united in their demands, they have so far been headless. The protesters have refused to present a list of acceptable replacement leaders, insisting that it is the government’s role to propose potential alternatives to the people. This has led to deadlock and will be a hurdle for the government in negotiating with demonstrators. On the other side of the conflict, the current political class, including Hezbollah leader Hassan Nasrallah, has expressed warnings about the chaos that would ensue with a government resignation. According to the Lebanese constitution, following Hariri’s resignation President Aoun is now tasked with consulting Lebanon’s fractured parliament to determine the next prime minister – a role reserved for a Sunni Muslim. However, if history is any guide, this process could take months and protesters are not that patient. Given that Hariri has sidelined himself and – unlike Parliament Speaker Nabih Berri or Foreign Minister Gebran Bassil – he is not the core target of protesters’ ire, there is a possibility that he may once again be appointed to the post of prime minister. While the outgoing government will take on a caretaker role until a new one is formed, demonstrators are standing their ground. ​​This has generated a political standoff causing Lebanese assets to bear the brunt (Chart 4). The emergence of competing rallies – in the form of support for President Michel Aoun – only complicates and possibly prolongs the situation. For now, the army is staying on the sidelines, allowing the protests to be – for the most part – a peaceful one. However, with Hezbollah also subject to the protesters’ wrath, odds of greater regional tensions have increased. Hezbollah may attempt to regain lost support by provoking Israel. The instability could also prompt Hezbollah to reassert its willingness to use force against domestic enemies, namely any new government that attempts to disarm it. In the meantime, Lebanon’s economy and financial markets will remain under pressure. The economy depends on capital inflows from citizens living abroad to finance the large twin deficit and maintain the dollar peg. Thus, the decline in sentiment will weigh on the economy (Chart 5). While the government has not implemented official capital controls, banks have independently tightened restrictions and raised transaction fees to reduce capital outflow. Chart 4Further Unrest Ahead Chart 5Weak Sentiment Weighs On Lebanon's Economy Bottom Line: Lebanese protesters and the political class are in deadlock. The prime minister’s resignation has done little to ease the tension, and demonstrators are refusing to back down until a new non-sectarian, technocratic government is formed. The domestic economy will remain frail. Earlier this week the central bank asked local lenders to boost their liquidity by raising their capital by 20% or $4 billion in 2020 in anticipation of potential downgrades. A stabilization of the political situation is a necessary precondition to boost confidence and once again shore up capital inflows. Nevertheless, with the protest movement being largely headless, the path toward compromise with the government will be challenging, raising the odds of prolonged tensions. What Of Iran’s Sphere Of Influence? “Not Gaza, Not Lebanon, I Give My Life For Iran” - Chants by Iranian protesters, January 2018 Iran has a strong incentive to preserve the established systems in both Lebanon and Iraq. The protesters’ demands risk weakening its grip on power in the region. In both movements, pro-Iranian forces have taken a stance against the protests with Hezbollah in Lebanon advising against the resignation of Prime Minister Hariri while the Iran-backed bloc in Iraq voiced concern over the chaos that will ensue with the prime minister’s resignation. Meanwhile, Tehran’s position is hardening. Iran is taking further steps away from the nuclear deal, injecting uranium gas into centrifuges at its underground Fordow nuclear complex, making the facility an active nuclear site rather than a permitted research plant. Chart 6Popular Support For Iran’s Hardening Stance Chart 7US-Iran Détente Unlikely This reflects the loss of public support for the JCPOA and the loss of confidence that other countries will honor their obligations toward the nuclear agreement (Chart 6). In a speech on November 3 marking the fortieth anniversary of the 1979 US Embassy takeover, Supreme Leader Ayatollah Ali Khamenei renewed his ban on negotiations with the US. His stance mirrors public opinion, which is moving toward an increasingly unfavorable view of the US (Chart 7). However, this does not mean that President Hassan Rouhani’s administration is immune to popular discontent. Rather, with Iranians living through a continued economic deterioration and assigning the most blame to domestic mismanagement and corruption, there could be cracks forming in Iran as well (Chart 8). Chart 8A Case For Unrest In Iran? Bottom Line: The ongoing US withdrawal from the Middle East opens opportunities for Iran to increase its regional influence. It has been capitalizing on such opportunities by lending support to its proxies in Syria, Yemen, Iraq, and Gaza. However, the escalation of unrest in Lebanon and Iraq pose a risk to Iran’s grip on power in the region. On the one hand, if the movements there result in new governments, Iran will witness its wings clipped. This could incentivize retaliation and violence in Iraq, and provocations by Hezbollah along Lebanon’s southern border in an attempt to regain lost support. On the other hand, a prolonged standstill between protesters and the governments could result in greater Iranian influence over the long term. Other foreign powers are unwilling to wholeheartedly intervene to fill an emergent power vacuum. Investment Implications The risk of a decline in Iran’s control over its sphere of influence and the still unstable state of Iraqi domestic politics suggest that the geopolitical risk premium in oil prices should remain elevated. For now, President Trump is still enforcing sanctions and Iran’s oil exports have largely collapsed (Chart 9). The White House is continuing to add pressure by warning Chinese shipping companies – the largest remaining buyer of Iranian oil – against turning off their ships’ transponders. Chart 9The US Maintains Pressure On Iran News reports indicate that oil workers in Iraq’s southern region have started to join the government demonstrations. Moreover, reports on Wednesday indicate that the 30k b/d of production from the Qayarah oil field has been shut down due to road blockades in Basra that are preventing trucks from transporting crude to the Khor al-Zubair port. The geopolitical risk premium in oil prices should remain elevated. While the impact on the country’s oil production and exports have so far been minimal, a prolonged standoff between protesters and the government could result in supply outages. Today’s environment is notably different than that of the ISIS invasion of Iraq in 2014. Tensions then did not create a geopolitical risk premium in oil as they occurred amid an oil market share war, which kept supply abundant. Similarly, the September attack on Saudi Arabian oil facilities did not result in a lasting price spike as it occurred at a time of weak global demand. Moreover, Saudi Arabia possesses the technology and spare capacity that permitted it to swiftly restore output and maintain export commitments. The same cannot be said today about Iraq. A disruption there would be of greater consequence to oil markets, as illustrated by the 2008 Battle of Basra. Especially given Saudi Arabia's need to maintain high prices and amid the Aramco IPO and the tailwind created by a rebound in global growth. The fall in global economic policy uncertainty as the US and China move toward a trade ceasefire will weaken the dollar and support global demand for oil, which is overall bullish for oil prices. Moreover, US-Iran tensions remain unresolved which pose risks to production and shipping infrastructure in the region. We remain tactically long spot crude oil on the back of the geopolitical risks to supply as well as an expected revival in global demand. We are booking a 4.6% gain on our GBP-USD trade but remain long sterling versus the yen. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1    The ‘land bridge’ is an aspirational route by which Iran would create a strategic corridor to the Mediterranean, stretching through friendly territory. 2   Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 3   Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. 4   Under the current system, Lebanon’s president has to be a Maronite Christian, the parliament speaker a Shiite Muslim and the prime minister a Sunni. Cabinet and parliament seats are equally split between the two Muslims groups and Christians.

Highlights Please note that we will publish a Special Report on the Asian semiconductors cycle on Monday November 11. The risk to our negative stance on EM stocks is that DM share prices will continue advancing, pulling EM equities higher. If the MSCI EM Equity Index breaks decisively above our stop buy level instituted two weeks ago, we will reverse our stance on the absolute performance of EM. Nevertheless, we assign high odds that EM share prices will underperform DM even in a global equity rally. Hence, we are not changing our underweight recommendation on EM within a global equity portfolio. In the 2012-14 period, EM stocks underperformed their DM counterparts despite the global equity rally. Feature Chart I-1China: A Tale Of Two Manufacturing PMIs In our October 24 weekly report, we instituted a buy stop on the MSCI EM Equity Index at 1,075. The index is currently flirting with this level. If EM stocks break decisively above this level, our buy stop will be triggered. Such a technical breakout will signify that this EM equity rally will likely be sustained in the medium term, and that investors should play it. What would be the rationale behind this rally? Is it the rise in China’s Caixin manufacturing PMI or an imminent trade deal between the U.S. and China? Or is it a recovery in the global business cycle? The top panel of Chart I-1 shows that China’s Caixin and NBS manufacturing PMIs have decoupled. The Caixin PMI is compiled through a survey of about 500 companies, while the NBS measure is based on about 3000 companies. Neither one appears to have a consistently better track record than the other. For this reason, to tackle the issues of excessive volatility and false signals from both measures, we prefer to look at their average. The bottom panel of Chart I-1 illustrates the average of the two. The takeaway is that China’s manufacturing PMI has indeed improved, but only modestly. Further, non-manufacturing PMI – also the average of the Caixin and the NBS figures – has dropped to 2015 lows (Chart I-2). Hence, Chinese PMIs are not sending an unequivocal message that the mainland economy is recovering. Chart I-2China: Non-Manufacturing PMI Is At Its 2015 Low On one hand, the business cycle in China as well as global trade and manufacturing have not yet improved. On the other, share prices often lead markets, and waiting for economic data often results in missing the turning points. In this week’s report, we present both the bullish market signals and the lack of evidence of an economic recovery in China/EM, global trade and manufacturing. Finally, we elaborate why an enduring global equity rally does not always lead to EM equity relative outperformance versus DM. Bullish Market Signals… The motive for our buy stop on the EM Equity Index is the number of bullish market signals that currently suggest the global equity rally could be sustainable, and hence playable. First, DM share prices have been trading well – equity market actions in the U.S., Europe and Japan have been characteristic of a bull market since early October. Specifically, companies that have missed analysts’ earnings estimates have seen their share prices do quite well, often rising markedly in the days following their earnings announcements. Share prices of companies that have beaten analysts’ expectations have literally surged. This is typical of a genuine bull market. Technical patterns are also positive for U.S. equities. U.S. small caps, S&P 500 high-beta stocks and FAANG share prices have all bounced from major support levels. Second, technical patterns are also positive for U.S. equities. U.S. small caps, S&P 500 high-beta stocks and FAANG share prices have all bounced from major support levels and are attempting to break out (Chart I-3). Finally, the U.S. stock-to-bond ratio has also failed to break below one of its long-term moving averages and has rebounded (Chart I-4). When a 200-day or long-term moving average holds, it often marks a major reversal. Chart I-3Bullish Patterns In U.S. Equities Chart I-4A Bull Market In U.S. Stocks-To-Bonds Ratio   All these signals imply a bullish trajectory for U.S. and other DM share prices. At the current juncture, we are giving the benefit of the doubt to the market and ready to reverse our stance on EM performance in absolute terms when our buy stop is triggered. Apart from these technical signals and market actions, U.S. economic fundamentals remain healthy. In particular, U.S. households have decent balance sheets, their income and spending growth is quite robust, the banking system is healthy, and nationwide property markets are picking up following a soft spot early this year. Although American manufacturing and capital spending have been weak, these relapses primarily reflect negative demand from the rest of the world and business confidence deterioration due to the U.S.-China trade confrontation. The latter will be partially reversed by the forthcoming U.S.-China trade deal. Chart I-5China Not U.S. Drives EM Profits Cycles At the same time, there is a lack of meaningful green shoots in global trade and manufacturing (we discuss this in more detail below). Altogether, one can explain this equity rally as being driven by subsiding fears of a U.S. recession, Federal Reserve easing and the improvement on the U.S.-China trade front.  That said, our negative view on EM has not been contingent on a U.S. recession, Fed policy or the U.S.-China trade confrontation. As such, improvements on these fronts do not constitute sufficient basis for us to change our fundamental stance on EM. The empirical evidence that U.S. growth is not driving EM growth in general and EM corporate profitability in particular emanates from the following: U.S. imports and EM corporate earnings cycles have not been correlated since 2011 (Chart I-5, top panel). EM earnings-per-share cycles have instead been driven by Chinese imports since 2009 (Chart I-5, bottom panel). Hence, it is China’s domestic demand that drives broader EM profit cycles. As we elaborate below, there is little evidence of improvement in the mainland’s business cycle, its imports, and commodities prices. Bottom Line: There are numerous bullish signals from DM equity markets. The risk to our negative stance on EM is as follows: If DM share prices continue to rally, they will drag EM stocks and other risk assets higher. …But Global Growth Has Not Yet Improved Chart I-6No Clear Bullish Signal From Currency Markets Several key financial market signals, as well as soft and hard data, are not yet indicating that a recovery is already underway in global trade and manufacturing. Nor do they point to an improvement in China/EM economies. Our Risk-On/Safe-Haven currency ratio1 has rebounded but has not yet broken above its neckline (Chart I-6, top panel). This indicator had formed a classic head-and-shoulders pattern before breaking down. The jury is still out on whether the recent rebound is a false start or the beginning of a cyclical advance. We put a lot of emphasis on this indicator because (1) it is very strongly correlated with EM share prices, (2) it captures both risk-on and risk-off periods in global financial markets, (3) it leads the global business cycle, and (4) it is agnostic to the U.S. dollar’s trend. In a similar vein, the broad trade-weighted U.S. dollar has weakened but has not yet broken through key moving averages to conclude that it has definitively entered a bear market. With the exception of China’s Caixin manufacturing PMI, there are few green shoots in global manufacturing. Manufacturing PMIs in Japan, Korea, Singapore and Taiwan are all still below the 50 boom-bust line (Chart I-7, top and middle panels). Meanwhile, manufacturing PMIs in the ASEAN region have plunged (Chart I-7, bottom panel). Critically, EM per-share earnings are contracting at a rate of 10% from a year ago. Notably, the leading indicators for EM corporate profits – China’s domestic orders of 5,000 industrial companies and narrow money (M1) growth – signal a tentative bottoming of EM corporate profit growth only in early 2020 (Chart I-8). Chart I-7Outside China, Asian Manufacturing PMIs Are Weak Chart I-8Leading Indicators For EM EPS Growth   In the majority of developing economies, corporate per-share earnings are contracting or stagnating in local currency terms (Chart I-9). Our Risk-On/Safe-Haven currency ratio has rebounded but has not yet broken above its neckline. “Hard” economic data out of EM/China and global trade remain downbeat as well. For example, Chinese construction activity and capital goods imports as well as Japanese foreign machine tool orders are all shrinking at double-digit rates from a year ago (Chart I-10, top and middle panels). Korea’s October exports contracted by 15% from a year earlier (Chart I-10, bottom panel).   Chart I-9Individual EM Country EPS In Local Currency Terms Chart I-10China Capex And Global Trade: Double Digit Contraction   Finally, the import sub-component of China’s NBS manufacturing PMI remains well below the 50 boom-bust line. Chinese demand is of paramount importance for industrial metals. China accounts for 50% of industrial metals demand, while the U.S. accounts for only about 7%. The very subdued bounce in commodities in general and industrial metals prices in particular, are confirming a lack of recovery in Chinese intake of raw materials (Chart I-11). EM share prices, including emerging Asian stocks, have the highest correlation with global materials stocks (Chart I-12). The rationale for this tight relationship between emerging Asian equities and commodities is that both are leveraged to the Chinese business cycle, as we discussed in our recent report, EM: Perceptions Versus Reality. It is difficult to envision EM share prices staging a cyclical bull market when commodities prices are flat to down. Chart I-11Chinese Imports PMI And Industrial Metals Chart I-12Emerging Asian Stocks And Global Materials: Moving In Tandem   Bottom Line: The key variables driving EM share prices are China’s credit and business cycles, its imports and global trade. There are few green shoots in China/EM business cycles and global trade. This is why we believe even if this global equity rally is sustained, EM equities will underperform DM ones. We elaborate on this below. Can EM Underperform DM In A Bull Market? Chart I-132012-14: EM Underperformed During Global Bull Market BCA’s Emerging Markets Strategy team’s view on global equity allocation is as follows: Even if DM equities enter a sustainable bull market, odds are that EM stocks will underperform. This scenario will likely resemble the 2012-14 episode that was characterized by the following: DM share prices were in a strong bull market following the European credit crisis and the global markets selloff in 2011 (Chart I-13, top panel). Global trade and manufacturing bottomed in late 2012 and accelerated in 2013 (Chart I-13, third panel). Yet, this global trade and manufacturing improvement did little to support EM share prices, currencies and commodities prices. In 2012-14, EM equities were range-bound in absolute terms and significantly underperformed their DM peers (Chart I-13, second panel). In short, EM stocks were low beta relative to global stocks during that period. Besides, commodities prices were falling and EM currencies were depreciating versus the U.S. dollar (Chart I-13, bottom panel). The cause of such poor EM performance was two-fold: First, the recovery in China’s business cycle and its imports was tame. Second, many EM economies were suffering from poor domestic fundamentals following the 2009-2011 credit and cheap money booms. We expect any growth improvement in China to be muted, resembling the 2012 growth stabilization rather than the 2016 recovery. The top panel of Chart I-14 illustrates that China’s manufacturing PMI oscillated between 48 and 52 in 2012-2014 when the global manufacturing cycle rebounded and DM growth improved. This occurred despite China’s large stimulus in 2012 (Chart I-14, bottom panel). Chart I-14Chinese PMI And Credit And Fiscal Stimulus In line with the subdued recovery in China’s business cycle at the time, EM corporate profits did not recover much in the 2012-2014 period (please refer to Chart I-8 on page 7). We expect EM currencies to depreciate versus the U.S. dollar even if global share prices continue rallying. This will resemble the 2012-14 scenario. Notably, EM equity underperformance versus DM escalated in the spring of 2013 during the Fed’s Taper Tantrum when EM currencies plunged and EM fixed-income markets sold off. Yet, the Fed’s Taper Tantrum was not the only reason for EM currency depreciation. As demonstrated in the bottom panel of Chart I-13 on page 10, EM ex-China currencies’ total return was strongly correlated with commodities prices. Currently, many EM countries do not suffer from the same malaises they did in 2012-14, namely, high inflation and large current account deficits. On the contrary, very low nominal growth, i.e., enduring deflationary pressures, is the foremost problem in many EM countries such as India, Indonesia, Malaysia, Korea, Brazil, Mexico and Russia. These deflationary pressures are due to very sluggish domestic demand, weak/unhealthy banking systems and falling commodities prices. This backdrop indicates that these economies are not in a position to withstand either higher global borrowing costs or lower commodities prices. Their currencies will depreciate with either higher global bond yields or falling commodities prices. Even if DM equities enter a sustainable bull market, odds are that EM stocks will underperform. Hence, a scenario of firming U.S. and European demand – which would warrant higher bond yields – amid still weak Chinese growth – which would push commodities prices lower – would be very negative for EM currencies. Chart I-15Outperformance By Euro Area And Value Stocks Does Not Always Herald EM Outperformance Chart I-16EM Vs. DM: Relative Share Prices Are Tracking Relative EPS Finally, EM stocks’ relative performance versus global stocks does not always coincide with the relative performance of euro area or value stocks (Chart I-15). This entails that outperformance by euro area and global value stocks does not always herald EM outperformance versus the global equity benchmark. Bottom Line: Regardless the direction of global share prices, we expect EM stocks to underperform DM equities in the next several months. Relative equity performance is driven by relative EPS trends, as illustrated in Chart I-16. The corporate earnings outlook is worse in EM than in the U.S., euro area and Japan.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations