アメリカ合衆国

Highlights Trump is now clearly retreating from policies that harm the economy and reduce his reelection chances. Geopolitical risks are abating for the first time since May – a boon for financial markets amid global policy stimulus. The U.S. and China are containing tensions in the short term – though we remain skeptical about a final trade agreement. The U.S. election cycle is a rising source of political risk even as global risks fall – but Warren is not a reason to turn cyclically bearish. Book gains on our long spot gold trade. Feature President Trump is staging a tactical retreat from his “maximum pressure” foreign and trade policies. As a late-cycle president with an election looming, his decision to escalate conflicts with China and Iran in May revealed a voracious risk appetite. This “war president” mentality – the idea that Trump would reconnect with his political base ahead of 2020 at the risk of undermining his own economy – led us to recommend a defensive position over the course of the summer, even though we remained cyclically bullish. Now with Trump’s backpedaling this tactical narrative is starting to turn. The shift adds policy support to the recent up-tick in critical risk-on indicators (Chart 1). While U.S.-China fears have played a much greater role than Brexit in the political tailwind behind global government bond yields (Chart 2), the collapse of Boris Johnson’s no-deal gambit is also helping geopolitical risk to abate. Chart 1Risk-On Indicators Flash Green Chart 2China Political Risk To Ease (Brexit Is Nice Too) Unfortunately, it is too soon to sound the all-clear: The U.S. election cycle still warrants caution. As we highlighted in July, the rise of the progressive wing of the Democratic Party, particularly firebrand Senator Elizabeth Warren of Massachusetts, is causing jitters in the marketplace. Warren is on the cusp of displacing Vermont Senator Bernie Sanders as the second-place candidate behind former Vice President Joe Biden. Biden remains the frontrunner – which helps to support a constructive cyclical view – but the progressives have a tailwind and his status could change. Moreover, the entire primary process and U.S. election cycle will engender policy uncertainty and “black swan” risks. Trump’s pivot could come too late to save the bull market. There are still significant risks to our House View that equities will be higher in a year’s time. If a bear market and recession become a foregone conclusion, then Trump will have to return to a war footing. This means escalating the conflict with China or confronting Iran in a desperate bid to get voters to rally around the flag. This is a substantial political risk given that the odds of a recession are elevated and rising. Despite these risks, it is significant for the global macro view that President Trump is making a last ditch effort to save the business cycle while it can still be saved. This supports BCA’s House View that investors should maintain a cyclical risk-on orientation. How Do We Know Trump Is In Retreat? Here are the critical signs that Trump is downgrading his administration’s level of aggression after another summer of “fire and fury”: The U.S. and China are now officially easing tensions. Trump has delayed the October 1 tariff hike (from 25% to 30% on $250 billion worth of goods), while China has issued waivers for tariffs and promised to increase purchases of U.S. farm goods in advance of talks. Talks are resuming with the principal negotiators set to meet face-to-face after China’s National Day celebration on October 1. Critically, the two sides are reportedly picking up the nearly completed draft text of a trade agreement that was abandoned in May when divisions over compliance and tariffs resulted in a breakdown. Trump and Xi Jinping have an occasion to meet in Santiago, Chile in November, which is the best time for a signing if the talks progress well. Trump fired his hawkish National Security Adviser, John Bolton. Bolton was a supporter of the president’s “maximum pressure” foreign policy toward rivals, including China as well as Iran and North Korea. Oil prices dropped on the expectation that U.S. relations with Iran could improve, easing oil sanctions and increasing supply (Chart 3). But ultimately the signal is bullish for oil. The real significance is not Bolton himself but rather that Trump is changing tack to reduce geopolitical risks to economic growth. Whoever replaces Bolton is far less likely to be an uber-hawk (Bolton had cornered that market). A trade deal with Japan has been agreed in principle and may be signed in late September. U.S. relations with Europe are marginally improving. Trump even sent Secretary of State Mike Pompeo on a trip to discuss a diplomatic “reset” with the EU’s new crop of leaders set to take power in November and December. These improvements are tentative. Trump still explicitly rejects the idea that he should court Europe to apply unified pressure on China. But his administration has agreed to a beef export deal with the EU and, as long as China talks are ongoing, he is unlikely to slap tariffs on European cars. This decision will likely be postponed beyond November 14. All of the above confirms that Trump is focused on reelection. But how can we be sure this less-hawkish policy turn will last longer than five minutes? Rising unemployment is the most deadly leading indicator of a president’s approval rating. Economic data is alarming for a sitting president. Following a drop in business sentiment and investment, consumer sentiment is now suffering (Chart 4). Manufacturing – the sector Trump was ostensibly elected to defend – has slipped into outright contraction and loans and leases are shrinking in the electorally vital Midwestern states (Chart 5). Chart 3Bolton Bolting Is Bullish For Brent Chart 4A Reason For Trump To De-Escalate Fortunately for Trump, the job market is showing signs of resilience, with initial unemployment claims dropping hard (Chart 6). Chart 5Another Reason For Trump To De-Escalate Chart 6Good News For Trump Chart 7U.S. Consumer Should Prevent Recession BCA does not expect a recession within the next 12 months. The American consumer remains buoyant and median family incomes are strong (Chart 7). Nevertheless, Trump cannot assume anything. The proliferation of the “R” word has a negative psychological effect on businesses and consumers that could create a negative feedback loop. It also raises the risk of an equity selloff that tightens financial conditions and exacerbates the slowdown (Chart 8). Trump’s Democratic opponents and much of the news media will amplify negative economic news. Chart 8Trump Needs To Change The Topic While Trump cares about the stock market, his election ultimately rests on voters, not investors. Even if recession is avoided, a rising unemployment rate would be the most deadly leading indicator of a sitting president’s approval rating (Charts 9A & 9B). It is a far more telling variable than income growth or gasoline prices, for example. Chart 9APresidential Approval... Chart 9B...Follows Unemployment As Charts 9A & 9B demonstrate, unemployment and presidential approval are not always tightly correlated. Rather, for all recent presidents, the direction of unemployment ultimately prevailed over the approval rating by the time of the election – it pulled approval up or down in the final lap of the term in office. Moreover Trump, a bull-market president, is one of the cases where the approval rating is indeed tightly correlated with unemployment, as with Bill Clinton. And he is particularly vulnerable because his approval is historically weak and the unemployment rate can hardly fall much further from today. Granting that Trump is now going to adopt a more pro-market foreign and trade policy orientation, the next question is: what will that entail? Bottom Line: Trump’s tactical policy retreat is materializing which means that geopolitical risk stemming from U.S. foreign and trade policy is declining on the margin. While Trump is unpredictable, his sensitivity to the drop in his polling and weakening economy shows he wants to be reelected. Hence policy will have to moderate. Bolton Bolts – Geopolitical Risks Abate Trump’s ousting of his National Security Adviser Bolton is an important sign of the less-hawkish shift in administration policy. The ouster itself is not surprising in the least. Trump ran for office on a relatively isolationist foreign policy of non-intervention, withdrawal from long-running wars, and eschewing regime change and foreign quagmires to focus on America’s commercial interests. By contrast Bolton is perhaps the Republican Party’s most outspoken war hawk – a neo-conservative of the Bush era who advocated regime change in North Korea and Iran. This position was always at odds with Trump’s eagerness to negotiate and strike deals with the world’s dictators in the name of trade and riches rather than war and expenses.1 Chart 10Will Xi Sell Pyongyang For Washington? The immediate implication is that the U.S. and Iran will reduce tensions. We will address this topic at length next week, but the gist is that Trump is much more likely to relax sanctions and hold a summit with Iranian President Hassan Rouhani now than before. This is in keeping with our view that the China trade war is a far greater geopolitical risk than the U.S.-Iran tensions post-withdrawal from the 2015 nuclear pact. However, Bolton’s firing is bullish for oil prices. Iran may still stage low-level provocations that threaten supply, but Saudi Arabia has also appointed a new energy minister in preparation for an OPEC 2.0 strategy that aims to bolster prices in the advance of the initial public offering of Aramco.2 At the same time, Trump’s softening foreign policy stance portends an improvement to the global economy. Nowhere is this clearer than with North Korea and China. Kim Jong Un has explicitly demanded Bolton’s replacement to get talks back on track – Trump has now met this demand. North Korea has also been an integral component of the U.S.-China negotiations throughout Trump’s administration. If Trump’s diplomacy succeeds with North Korea, markets will rightly conclude that U.S.-China tensions are falling. China has an interest in denuclearizing the peninsula, which ultimately entails getting rid of U.S. troops, so it has shown it can comply with U.S. sanctions (Chart 10). A third Trump-Kim summit that results in a nuclear deal of any kind would be a concrete policy win for Trump and a strategic win for China.   The North Korean threat itself is not market-relevant – war risk peaked in 2017 (Chart 11). But an official agreement would provide an “off-ramp” for U.S.-China trade tensions. It would boost trade talks enough to improve global sentiment, and it could even increase the chances that the two countries conclude a deal involving tariff rollback. A Trump-Kim agreement would provide an “off-ramp” for U.S.-China trade tensions. Bolton’s ouster could also smooth U.S.-China tensions over Taiwan – he was an outspoken hawk on this front as well. His presence encouraged fears in Beijing that the Trump administration was planning a significant upgrade in Taiwan relations. These apprehensions were already high from the moment Trump accepted President Tsai Ing-wen’s congratulations on his election in 2016. It remains to be seen whether Trump will delay an $8 billion arms sale that will be the biggest since 1992 (Chart 12) – China has threatened to sanction U.S. defense firms if it goes ahead. But postponement is more likely now than before. This would help along the trade talks. Chart 11North Korea: 'Off-Ramp' For US-China Tensions Chart 12Will Trump Sell Taipei For Beijing? The direction of Taiwan in the near term partly depends on the direction of Hong Kong. Bolton likely advised a hard line in defense of the mass pro-democracy protests, which Trump was inclined to neglect for the sake of the trade talks with Beijing. Unless a mainland intervention and bloody security crackdown occurs – which is still a risk, and would make it politically impossible to conclude a trade deal with China – Trump will probably continue to sideline this Special Administrative Region. The jury is still out on whether protests will escalate after China’s National Day celebration, but Bolton’s absence and Hong Kong’s concessions to the protesters (which are backed by Beijing) are both positive signs. All of these factors suggest that the odds of a U.S.-China trade deal by November 2020 should rise. But is that really the case? For now we are maintaining our view that the odds are 40% by November 2020, though the risks are to the upside. Chart 13Trump Can Partially Offset China Tariffs While Trump and Xi can certainly make an executive decision to agree to a deal – any deal – we maintain our high-conviction view that it will lack durability due to uncertainties regarding compliance on China’s side and faithfulness on Trump’s side. And a shallow deal may be politically untenable if markets and the economy rebound. Crucially, neither China’s economic data nor U.S. financial conditions are forcing either side to capitulate entirely. Trump’s policy retreat entails the removal of trade risks from Canada, Mexico, and Japan first and foremost, and likely the European Union. This will offer some consolation to markets even though the small increase in U.S. exports in the near-term will not offset the sharp drop in exports to China (Chart 13). Combined with a de-escalation and containment of tensions with China, and worldwide monetary and fiscal stimulus, markets will face a substantial policy improvement. This will actually reduce the incentive for a final trade deal. If financial and economic pressure intensify and the U.S. heads toward a technical correction or bear market, Trump will need to capitulate. This will require significant tariff rollback. At that point, Xi Jinping will have the opportunity to agree to a short-term deal based on China’s current concessions and nothing more (Table 1). This would demonstrate to the whole world that it does not pay to coerce China: China operates on mutual respect and win-win agreements. This would be acceptable to Xi Jinping since it would at least buy some time until the inevitable second round of the strategic conflict in 2021. But we are not at full capitulation yet. Table 1China’s Offers Thus Far In The Trade War Bottom Line: Trump’s policy retreat includes the ouster of Bolton, which deescalates geopolitical risk on several fronts. Nevertheless, none of these risks – Iran, China, North Korea, Hong Kong, Taiwan – is fundamentally resolved. A U.S.-China trade agreement is not even necessary if the two political leaders are sufficiently supported by positive global macro developments. We continue to believe North Korea will lead to Trump diplomatic successes. De-escalation could lead to a breakthrough in trade talks pointing toward a deal, but it could also simply create an “off ramp” for the U.S. and China to contain tensions without having to capitulate on the trade front. Warren Still Warrants Caution While geopolitical risk has some room to abate, domestic political risk in the U.S. will pick up the slack. The entire American election cycle will trouble the markets over the coming 12 months – particularly due to the high chances of significant social unrest. Yet the greatest risks are frontloaded in the form of the Democratic Primary contest. This is because Warren will continue to do well in the early primary debates and therefore could soon morph into the biggest market risk of the entire election cycle. To be clear, her position as the frontrunner in the online betting markets is not validated by the national or state-level opinion polling. Biden remains dominant (Chart 14). If he stays firm above a 30% support rate, with double-digit leads over his nearest competitors in a range of important states, his chances of winning will rise over time and market uncertainty will fall. Chart 14Biden Still The Frontrunner In Democratic Primary While Biden’s election would be market-negative on the margin due to the outlook for tax hikes and re-regulation, Trump’s reelection is not as market-positive as some may believe since he will be unbridled in his second term and more capable of pursuing his aggressive protectionism. Ultimately, the choice between Trump and Biden is a choice between two candidates whose policies and flaws are well known and relatively digestible by markets. If Warren or Sanders come close to the Oval Office, the equity market will go through a re-rating. On the contrary, if Warren surpasses Sanders and takes the lead, uncertainty will skyrocket regardless of Trump’s advantages in the general election. This is not unlikely, as the leftward lurch within the party continues to propel the progressive candidates upward in the contest (Chart 15). If Warren or Sanders are seen as coming within one step from the Oval Office, the equity market will have to go through a re-rating. These progressive populists are proposing an onslaught of laws and regulations against banks, health insurers, oil and gas drillers, and the tech oligopoly. The agenda is inherently negative for corporate earnings in these sectors, as Peter Berezin of BCA’s Global Investment Strategy shows in a recent report.3 Chart 15Progressive Consolidation Would Increase Market Angst Chart 16Stocks Will Start To Trade On Polls Health stocks are clearly reacting to Warren’s surge in the online betting markets (Chart 16), so any convergence of the polling of real voters to these probabilities will cause a reckoning in this sector as well as in other sectors she has targeted, like financials, technology, and energy. The saving grace for now – a reason we remain cyclically bullish – is that Biden has not yet broken down in the polling. He is the least market-negative of the top three candidates, yet the most electable from the point of view of the swing state polling and electoral-college calculus. Warren is the most market-negative yet least electable of the top three. She must decisively surpass Sanders in order to create lasting volatility. Yet this will be hard to do because his electoral-college path to the presidency is clearer than Warren’s, judging by head-to-head polls with Trump, and he has the machinery and motivation to slog through the primary race for a long time – which undercuts both him and Warren versus Biden. Warren and Sanders are also less likely to lead the Democrats to victory in the senate even if they take the White House due to their lack of appeal in key senate races like Arizona and Georgia. Without a majority in the senate, their radical policy agenda will have to be left at the door. Investment Implications We are booking gains on our long spot gold trade at 16% since initiation. The thesis remains sound and we will reinitiate when appropriate.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Bolton’s tenure with Trump began with an incredible faux pas in which he advocated “the Libyan model” for the administration’s North Korean policy – prompting Trump to overrule him and reject that model. No comment could have been more inappropriate for a president trying to build trust with Kim Jong Un to sign a denuclearization deal. Libyan dictator Muammar Gaddafi was killed by enemy militias in Libya after NATO warplanes bombed his convoy – NATO’s intervention occurred despite Gaddafi’s having abandoned his nuclear weapon program in the wake of the September 1, 2001 attacks to avoid conflict with the U.S. and its allies. 2 See BCA Commodity & Energy Strategy Weekly Report, “Ignore The KSA-Russia Production Pact, Focus Instead On Their Need For Cash,” September 8, 016, ces.bcaresearch.com. 3 See BCA Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” September 1, 2019, gis.bcaresearch.com.

Commodity demand appears to be turning up, based on our assessment of global industrial activity. As demand picks up, we expect industrial commodity prices will move higher (Chart of the Week, top panel). For all practical purposes, central banks and numerous governments have moved into recession-fighting mode, following the contraction in manufacturing activity brought on by the U.S. Fed’s rates-normalization policy last year, and China’s deleveraging campaign in 2017-18. Together, these policies severely retarded credit and liquidity available to markets, and drove the USD higher, to the detriment of commodity demand (Chart of the Week, middle panel). Current policy responses will support a revival of manufacturing, and with it, global trade (Chart of the Week, bottom panel). While we continue to expect a weaker USD on the back of additional Fed easing this year and recovery of ex-U.S. economic growth in line with our House view, we remain wary uncoordinated global monetary accommodation by a large number of central banks could leave the dollar well bid. This could stifle the commodity-demand revival by keeping local-currency commodity costs high (Chart 2). This would be especially bearish for base metals prices.1 Chart of the WeekGlobal Industrial Activity Moving Higher Chart 2USD Strength Will Pose Risk To Industrial Commodity Demand Highlights Energy: Overweight. The appointment of Prince Abdulaziz bin Salman as the Kingdom of Saudi Arabia’s (KSA) new Energy Minister signals the royal family will push harder to manage production and reduce global oil inventories ahead of the IPO of Saudi Aramco. The prince brings more than 30 years of experience to the role, making him something of an outlier among KSA’s ministers – technocrats typically have occupied the position, and he is the first royal to serve as Energy Minister. We believe the prince’s immediate goal is to get Brent into the mid- to high-$70/bbl ahead of the IPO later this year or early next year. The first leg of the IPO reportedly will be done locally in the Kingdom, with Saudi investors taking ~ 1% of the Saudi Aramco float. Base Metals: Neutral. China imported 1.82mm MT of copper concentrates in August, a 9.3% increase y/y, as smelters continue to buy partly processed ores to feed expanding capacity. Concentrate imports in July were a record 2.07mm MT. Precious Metals: Neutral. The World Platinum Investment Council (WPIC) forecasts a 9% increase in platinum demand this year, driven primarily by ETF investors. This “more than offsets expected demand decreases in the automotive and jewellery segments of 4% and 5% respectively.” WPIC reduced its expected physical surplus this year to 345k ounces, from its earlier expectation of 375k ounces. Our tactical long platinum position recommended August 29, 2019 is up 1.9%. Separately, we are taking profits on our Long 10-year TIPS position at tonight’s close. It was up 9.3% on September 10, 2019. The position was recommended July, 27, 2017. Ags/Softs: Underweight. A wet start to the planting season points to lower corn and bean yields this year vs. 2018. AccuWeather expects 2019 corn yields will fall 7.35% y/y to 13.36 billion bushels, and soybean yields will be down 19.5% y/y to 3.658 billion bushels. Besides stressing crops at the beginning of the season, weather-related delays also increase the risk some of this year’s crop will be exposed to frost at the end of the season before it is harvested. Weather effects continue to be apparent in the USDA’s crop conditions report, particularly for corn, where the USDA now rates 55% of the U.S. crop good or excellent, vs. 68% a year earlier. Last week, the USDA rated 58% of the corn crop good or excellent. Feature Leading indicators are signaling the slowdown in global growth – i.e., aggregate-demand growth – likely bottomed ex-Europe (Chart 3). The chart shows easing global financial conditions, along with fiscal stimulus, most likely have arrested the slowdown in industrial commodity demand (Chart 4). Chart 3Manufacturing Downturn Likely Arrested Following Broad Monetary Stimulus Chart 4Global Financial Conditions Are Supportive Easier Financial Conditions Will Benefit Global Growth We expect the recovery in demand will be most visible in the LMEX base metals index and in oil markets. Base metals demand is highly concentrated in China – accounting for ~ 50% of global demand – and EM Asia.  Our EM Commodity-Demand Nowcast continues to signal oil demand also will revive in 2H19 as GDP growth picks up (Chart 5). Markets still could wobble, which is why the evolution of EM import volumes remains important, given their high correlation with GDP levels. A number of gauges we follow closely – particularly those associated with the movement of good on the sea (Chart 6) and in the air (Chart 7) – have turned up in 3Q19. We expect this to continue into 4Q19 and next year. Chart 5Monetary, Fiscal Stimulus Will Lift Oil Demand   Chart 6Shipping Gauges Signal Uptick in Movement of Goods Chart 7Air Freight Gauges Signal Uptick in Movement of Goods USD Strength Keeps Us Wary The contraction in manufacturing and EM trade volumes is largely the result of the Fed’s rates-normalization policy last year, and China’s deleveraging campaign in 2017-18, in our view. These policies raised the value of the USD, which raised local-currency costs of dollar-denominated commodities, and all other goods and services invoiced and funded with dollars (Chart 8). Indeed, as Chart 2 shows, oil prices and base metals prices in local-currency terms ex-U.S. are closer to their earlier highs when Brent was trading above $100/bbl. This redounded to the detriment of commodity demand.2 The Sino-U.S. trade war certainly does not help commodity demand. For the most part, however, we believe this affects demand expectations – i.e., capex- and investment-driven demand. We believe firms and households will reduce outlays and increase precautionary savings, as a buffer against an expansion of the trade war into a larger global conflict, which likely would impair global supply chains and growth prospects. Chart 8Strong USD Keeps Us Wary While we expect the USD to weaken as the Fed cuts its policy rate, in line with our House view, we reiterate the non-trivial risk that global monetary accommodation still could leave the dollar well bid.3 Rising negative yielding debts globally makes U.S. yields relatively attractive despite the ongoing easing, supporting capital inflows in U.S. fixed income markets. Investment Implications The coincidence of fiscal and monetary policy easing is showing up in our gauges of global economic activity and in our leading indicators. We remain long oil exposure and precious metals – gold on a strategic basis, silver and platinum on a tactical basis. As we see industrial commodity demand picking up, we will look to go long copper. Bottom Line: Our gauges of economic activity continue to point to a bottoming of the global ex-U.S. slowdown in industrial activity, particularly in manufacturing, which has been hard-hit by a downturn in auto output. We expect USD weakness to become a tailwind for industrial commodities; however, we are wary continued strength in the dollar – it is above its 1Q02 peak – could crimp industrial metals, and maybe even oil, prices (Chart 9). Chart 9USD TWIB Strength Hampers Industrial Commodity Demand   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      We use base metals demand, particularly for copper, as an indicator of EM industrial activity in our modeling. These markets are somewhat removed from the idiosyncratic forces driving oil supply-demand dynamics, particularly on the supply side, where OPEC 2.0 continues to maintain its policy of production discipline to reduce global inventory levels. OPEC 2.0 is the name we coined for the producer coalition lead by KSA and Russia, which was formed in 2016 with the explicit mission of reducing the global oil-inventory overhang resulting from the 2014-15 market share war launched by the original OPEC states in 2H14. 2      Last week we discussed USD strength vis-à-vis oil demand. Please see Central Bank Easing Key To Oil Prices. It is available at ces.bcaresearch.com. 3      A non-trivial risk is bounded at the lower end by Russian-roulette odds – i.e., 1:6 – in our usage of the phrase. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Neutral Global gold stocks have gone parabolic over the past four months and are in desperate need of a breather (top panel).  Simultaneously, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as market participants expect, this would likely exert upward pressure on global interest rates including the U.S. (bottom panel), especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Bottom Line: Downgrade the global gond mining index to neutral and move to the sidelines. Please see Monday’s Weekly Report for additional details. ​​​​​​​

Please note that this abbreviated weekly report complements today’s Special Report titled China’s Foreign Debt, And A Secret Weapon published in collaboration with BCA’s China Investment Strategy service. Feature A major rotation has commenced in recent days in global financial markets: beaten-down value companies have begun outperforming richly-priced U.S. growth stocks. This has cogently coincided with the rise in U.S. bond yields. Further, U.S. small caps have also begun outpacing U.S. large caps. Do these signals mean that EM will start outperforming DM in general and U.S. in particular? We do not think it is likely to occur on a sustainable basis. We agree that certain trends in global financial markets have become over-extended and a mean-reversion is overdue. U.S. bond yields have probably dropped much more than justified by U.S. economic strength. Although U.S. manufacturing, exports and capex have been extremely week/contracting, consumer spending is expanding at a decent clip. We believe fears of a full-blown U.S. recession are presently exaggerated. It is also critical to gauge what is the underlying cause of this financial market rotation. Is it receding fears of U.S. recession or China’s recovery or both? We believe that the rotation is caused by unwinding of recessionary fears in the U.S., not a revival in the Chinese economy or a recovery in global trade and manufacturing. Unwinding U.S. recessionary fears will not be sufficient to produce a strong and lasting rally in EM risk assets and currencies even if it leads to a breakout in DM share prices in absolute terms. EM risk assets and currencies are much more sensitive to China and global growth rather than to the U.S. economy. Watch The Dollar For Clues Chart I-1EM Relative Equity Performance Correlates With U.S. Dollar Whether the sell-off in global safe-haven bonds and outperformance of global cyclical vs. defensive equity sectors is due to a genuine recovery in China or the U.S. will be revealed in the trend of the U.S. dollar (Chart I-1). If the dollar continues grinding higher, it would entail that the recent financial markets rotation is due to amelioration in U.S. growth expectations and that there is little recovery in the Chinese economy as well as global manufacturing and trade. In this scenario, EM risk assets will underperform. On the contrary, if the greenback begins exhibiting persistent and broad weakness, it would signify that the reversal in global safe-haven bond yields and global cyclical stocks is due to a revival in Chinese demand. In such a case, a lasting recovery in global manufacturing and trade are likely. This would be consistent with a durable EM rally and outperformance. Chart I-2Bullish Technicals For U.S. Dollars So far, the greenback has remained well bid (Chart I-2). In addition, industrial commodities prices remain weak and have failed to rebound (Chart I-3). These entail that the recent spike in U.S. bond yields and outperformance of cyclical equity sectors is primarily due to unwinding of pessimism on U.S. growth rather than a reflection of growth amelioration in China. Notably, cyclical data out of China and global trade/manufacturing remain dismal. Chinese overall imports are contracting (Chart I-4). Chart I-3Breakdown Remains In Play Chart I-4Shrinking Chinese Imports Global semiconductor sales and car purchases continue shrinking at a rapid pace (Chart I-5). China’s credit and money growth and impulses appear to be rolling over, having failed to rise as much as in the previous stimulus episodes (Chart I-6). Finally, the pace of EM corporate EPS contraction is accelerating (Chart I-7). Any rally in EM share prices will be unsustainable without a bottom in EM EPS growth. Chart I-5No Improvement In Global Growth Chart I-6Chinese Credit Impulse Is Weak   Chart I-7EM EPS & Share Prices Bottom Line: The U.S. dollar has failed to sell off despite the optimism in global equity markets. This entails that any rebound and outperformance in EM risk assets and currencies will prove to be short-lived.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

We are removing the large cap bias we have had on a tactical basis since our December 2018 High-Conviction Call report and booking gains of 9% (top panel). We are also setting a stop near the 10% return mark to protect cyclical profits since the May 7, 2018 inception of the large cap bias. Rising interest rates along with diminishing odds of an ultra-easy Fed in the upcoming September FOMC meeting have kept the dollar upbeat with some trade-weighted Fed indexes vaulting to all-time highs. Large caps have significant foreign sourced sales exposure and an appreciating currency will eat into profits, a headache that small caps do not have to sweat over. In addition, there are early signs that investors are beginning to treat small caps as trade war insulated companies anew, given their domestic focus. Bottom Line: While we are not ready to book cyclical profits in our large over small cap preference (please see this Weekly Report for more details),1 in the near term our confidence in additional large cap gains has decreased and we recommend removing the large cap bias from the high-conviction call list for a gain of 9% since inception.   1      Please see U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com

 Remain Cyclically Overweight, But Remove from High-Conviction Overweight List Our 10% stop on the S&P software high-conviction call got triggered and we are obeying it, booking gains and removing this index from the high-conviction overweight list. As a reminder, we are still overweight the S&P software index on a cyclical basis since November 2017, with a trailing stop at a the 27% relative return mark that has yet to get hit (bottom panel). Software stocks have offered bulletproof returns for investors as they are mostly insulated from direct impacts of the U.S./China trade war. In addition, these secular growth stocks are also perceived as immune to a growth slowdown and the drubbing in interest rates since the November 2018 peak in the 10-year Treasury yield has been more than reflected in high-flying multiples. Now that interest rates are trying to bottom, investors have been quick to rein in some of their enthusiasm on the largest tech subsector. We still believe that artificial intelligence, augmented reality, SaaS and the push to the cloud have staying power and are not fads, however from a risk management perspective we are compelled to act and protect profits for our portfolio. Bottom Line: Crystalize 10% gains in S&P software index and remove it from the high-conviction overweight list. We are still cyclically overweight the S&P software index and remain prepared to book profits at the 27% relative return mark and downgrade this key tech subgroup to neutral. Such a downgrade will push the S&P tech sector to an underweight stance and also give our portfolio a defensive over cyclical tilt. Stay tuned.

Highlights Chart 1Waiting For A Manufacturing Rebound The 2015/16 roadmap is holding. As in that period, the ISM Manufacturing PMI has fallen into recessionary territory, but the Services PMI remains strong (Chart 1). As is typically the case, bond yields have taken their cue from the manufacturing index. The resilient service sector and global shift toward easier monetary policy will support an eventual rebound in manufacturing, and the Fed will continue to play its part this month with another 25 basis point rate cut. As for the Treasury market, much stronger wage growth than in 2016 will prevent the Fed from cutting rates back to zero. This means that the 10-year yield will not re-visit its 2016 trough of 1.37% (Chart 1, bottom panel). Strategically, investors should maintain a benchmark duration stance for now, but stand ready to reduce duration once the global manufacturing data stabilize. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 105 basis points in August, dragging year-to-date excess returns down to +323 bps. In remarks last week, Fed Chairman Powell noted that the Fed has lowered the market’s expected path of interest rates, and that he views this easing of financial conditions as providing important support for the economy.1  The July FOMC minutes echoed this sentiment, sending a strong signal that the Fed will do everything it can to prevent a significant tightening of financial conditions. The accommodative monetary environment is extremely positive for corporate spreads. In terms of valuation, Baa-rated securities offer the most value in the investment grade corporate bond space (Chart 2). Baa spreads remain 13 bps above our cyclical target (panel 2).2 Conversely, Aa and A-rated spreads are 2 bps and 1 bp below target, respectively (panel 3). Aaa spreads are 15 bps below target (not shown). The main risk to spreads comes from the relatively poor state of corporate balance sheets. Our measure of gross leverage – total debt over pre-tax profits – was already high, and was revised even higher after the Bureau of Economic Analysis’ annual GDP revision (panel 4). But for now, likely in large part due to accommodative Fed policy, loan officers aren’t inclined to cut off the flow of credit. C&I lending standards remain in “net easing” territory (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 114 basis points in August, dragging year-to-date excess returns down to +551 bps. The average index option-adjusted spread widened 22 bps on the month. At 385 bps, it is well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 49 bps above our target (Chart 3), B-rated spreads are 151 bps above our target (panel 3) and Caa-rated spreads are 398 bps cheap (not shown).3   Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 3.2% over the next 12 months. This translates into 207 bps of excess spread in the High-Yield index after adjusting for expected default losses (panel 4). That 207 bps of excess spread is comfortably above zero, though it is below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in August, dragging year-to-date excess returns down to -31 bps. The conventional 30-year zero-volatility spread widened 9 bps on the month, driven entirely by the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat at 29 bps. At 51 bps, the OAS for conventional 30-year MBS has widened back close to its average pre-crisis level (Chart 4). However, value is less attractive when we look at the nominal MBS spread, which remains near its all-time lows.4 The nominal spread has also widened less than would have been expected in recent months, considering the jump in refi activity (panel 2). The mixed valuation picture means we are not yet inclined to augment MBS exposure. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. An increase in Treasury yields would cause refi activity to slow, putting downward pressure on MBS spreads. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to +152 bps. Sovereign debt underperformed duration-equivalent Treasuries by 45 bps on the month, dragging year-to-date excess returns down to +442 bps. Local Authorities underperformed the Treasury benchmark by 31 bps, dragging year-to-date excess returns down to +212 bps. Meanwhile, Foreign Agencies underperformed by 11 bps, dragging year-to-date excess returns down to +141 bps. Domestic Agencies outperformed by 13 bps in August, bringing year-to-date excess returns up to +44 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +39 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 104 basis points in August, dragging year-to-date excess returns down to -46 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 9% in August, and currently sits at 85% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but slightly above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We shifted our recommended stance on municipal bonds from overweight to neutral near the end of July.5 The reason for the downgrade was that the sector had become extremely expensive. Yield ratios have risen somewhat since then, but not yet by enough for us to re-initiate an overweight recommendation. We also continue to observe that the best value in the municipal bond space is found at the long-end of the Aaa curve. 2-year and 5-year M/T yield ratios remain below average pre-crisis levels, while yield ratios beyond the 10-year maturity point are above. 20-year and 30-year Aaa M/T yield ratios, in particular, are the most attractive (panel 2). Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our recent shift to a more cautious stance was driven purely by valuation and not a concern for municipal bond credit quality. A further cheapening in the coming months would cause us to re-initiate an overweight stance.    Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in August, as the global manufacturing recession continued to pull yields down. At present, the 2/10 Treasury slope is just above the zero line at 2 bps, 11 bps flatter than at the end of July. The 5/30 slope is currently 60 bps, 9 bps flatter than at the end of July. Our 12-month Fed Funds Discounter is currently -98 bps (Chart 7). This means that the market is priced for almost four more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of uncertainty surrounding the timing of the next move higher in yields, four rate cuts on a 12-month horizon seems excessive given the underlying strength of the U.S. economy. For this reason, we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts over the next four FOMC meetings. One of those rate cuts will occur this month, but if the global manufacturing data recover, further cuts may not be needed. A short position in this contract continues to make sense. On the Treasury curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 174 basis points in August, dragging year-to-date excess returns down to -104 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.55% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate also fell 21 bps in August. It currently sits at 1.74%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.6 Eventually, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors also need to see evidence that inflation will be sustained near 2%. On that note, recent trends are encouraging. Through July, trimmed mean PCE is running at 2.22% on a trailing 6-month basis (annualized) and at 1.99% on a trailing 12-month basis (bottom panel). As a result, the 10-year TIPS breakeven inflation rate looks very low relative to the reading from our Adaptive Expectations model, a model based on several different measures of inflation (panel 4).7 Supportive Fed policy and rising inflation should support wider TIPS breakevens in the coming months, remain overweight.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in August, bringing year-to-date excess returns up to +74 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month. It currently sits at 28 bps, below its minimum pre-crisis level of 34 bps (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (see Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 16 basis points in August, dragging year-to-date excess returns down to +218 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 6 bps on the month. It currently sits at 69 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in August, dragging year-to-date excess returns down to +88 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 56 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 98 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of September 6, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of September 6, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +49 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 49 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of September 6, 2019)     Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 The nominal spread is simply the difference between MBS index yield and the duration-matched Treasury yield. No adjustment is made for prepayment risk. 5 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation