Currencies

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity A Revival In Industrial Activity A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive The RMB Is Not Expensive The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Euro Area Growth Will Recover Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? What Next For The Pound? What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Still Some Room To Run Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Slowdown Fully Priced In Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise Labor Incidents On The Rise Labor Incidents On The Rise Chart 5 China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Earnings Unlikely To Contract Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump A Key Constraint On Donald Trump A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Table 3CFIUS Is Mostly About China U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Chart 13 Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict. Chart 14 Chart 15   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Highlights Most currency pairs continue to trade toward the apex of tight wedge formations. History suggests major breakouts could be imminent. While the trade-weighted dollar has historically tended to be the best performing currency over a six-month period following a U.S. yield curve inversion, this window is rapidly closing. As the tug of war between data disappointments and easier financial conditions plays out, we intend to selectively add to more USD short positions. The pound is sitting exactly where it was after the 2016 U.K. referendum results, but the odds of a hard Brexit have significantly fallen since then. Place a limit buy on GBP/USD at 1.30. The RBA’s dovish shift was widely expected, while the RBNZ’s was not. Meanwhile, the Aussie dollar is sitting close to the epicenter of any Chinese stimulus. Buy AUD/NZD for a trade. Feature Markets have taken a risk-on tone this week. On the data front, there was strong improvement in the Chinese composite PMI, as well as broad increases in the services component of the PMIs across Europe and the U.S. Retail sales data out of Europe and Asia were above expectations and U.S. housing data is beginning to benefit from the fall in interest rates. Case in point, mortgage applications jumped almost 20% week-on-week, nudging the mortgage purchase index towards new highs. On the political front, China and the U.S. appear to be approaching a trade deal, and the U.K. has reached across the aisle to forge a Brexit deal that will potentially include stronger support from the Labor party. Despite these positives, there remain some dislocations in financial markets as investors digest whether financial conditions have eased enough globally to lift us out of the growth slowdown. Since 2015, both the Japanese Nikkei 225 index and the 10-year U.S. Treasury yield have moved in lockstep (Chart I-1). Right now, these two global growth barometers are sending opposing signals. The Nikkei index bottomed in December 2018 and is 13% off its lows, while at 2.5%, U.S. bond yields are not far off the trough made last week. Back in 2016, both indicators bottomed together in a unified response to the Federal Reserve’s dovish shift as well as Chinese stimulus. Every time the U.S. 10-year versus three-month spread has inverted, pro-cyclical currencies have gotten clobbered.  The important message is that monetary policy affects the economy with a lag, and over the last year, more central banks have tightened policy than at any time since 2011 (Chart I-2). Our central bank monitors are still falling, suggesting easy monetary policy is still required. It wasn’t so long ago that dismal manufacturing PMI readings from Europe and Japan sent equity markets into a tailspin, with the U.S. 10-year versus three-month spread inverting. At a minimum, this warns against betting the farm too early on pro-cyclical currencies. Chart I-1Who Is Right? Who Is Right? Who Is Right? Chart I-2Monetary Policy Still relatively Tight Monetary Policy Still relatively Tight Monetary Policy Still relatively Tight       Bottom Line: Every time the U.S. 10-year versus three-month spread has inverted, the U.S. trade-weighted dollar has tended to be the best performing currency over the next six months, while other pro-cyclical currencies have gotten clobbered. This occurred whether or not the inversion was a head-fake (Chart I-3). Our bias is that this time is different, but we will await further confirmation from higher-frequency indicators before building aggressive USD short positions. Chart I-3ABeware Of Curve Inversions (1) Beware Of Curve Inversions (1) Beware Of Curve Inversions (1) Chart I-3BBeware Of Curve Inversions (2) Beware Of Curve Inversions (2) Beware Of Curve Inversions (2) What To Watch In our March 8th bulletin,1 we detailed the case for fading U.S. dollar tailwinds and what to watch for in order to adopt a more pro-cyclical stance. These included PMI differentials between the U.S. and the rest of the world, copper- and oil-to-gold ratios, Chinese M2 relative-to-GDP, emerging market currencies, and China-sensitive industrial commodities. The message from these indicators remains broadly consistent with what was observed a month ago, so we will not reprint them here. That said, there are a few additional indicators to consider. AUD/JPY: This cross has broadly tracked swings in the global manufacturing pulse, given the Australian dollar benefits from improving global growth, while the yen benefits from flights to safety and deteriorating liquidity (Chart I-4). The cross has been dead flat around 79 for three months, suggesting these two forces are largely in a stalemate. A break higher in the cross towards the 82-83 zone would be encouraging. EUR/USD: For the U.S. dollar to weaken significantly, the euro will have to strengthen meaningfully, given the large share of euros in global reserves. Following dismal manufacturing PMI numbers out of Europe, the more domestic service-oriented PMIs have proven more resilient. Yet they still point to GDP growth between 1%-1.5% (Chart I-5). The external sector will have to participate to finally put a floor under the euro. It is encouraging that the euro has weakened significantly relative to the Chinese RMB, which should help European exports to China. Chart I-4Bottoming Processes Could Last A While Bottoming Processes Could Last A While Bottoming Processes Could Last A While Chart I-5Dollar Weakness Needs A Strong Euro Dollar Weakness Needs A Strong Euro Dollar Weakness Needs A Strong Euro     Chinese Bond Yields: A larger share of financial intermediation is now being done through the Chinese bond market, meaning it has the power to ease financial conditions. There is significant debate as to whether Chinese credit stimulus has been sufficient, but bond yields suggest this has been the case (Chart I-6). We will be watching the Chinese aggregate money data for further confirmation that it is time to put on reflation trades.   Chart I-6All Confirmatory Signs From China Count All Confirmatory Signs From China Count All Confirmatory Signs From China Count Bottom Line: We noted last week that exports to China from Singapore jumped by 34% year-on-year and those to emerging markets by 22% year-on-year. Recent data from Taiwan corroborate the improvement in the Chinese manufacturing PMI for the month of March. With many currency pairs trading toward the apex of tight wedge formations, history suggests breakouts are imminent. Given that currency crosses can themselves be indicators, we will wait for confirmation of a breakout before putting on fresh pro-cyclical positions. Westminster Unifies It has been almost three years since the British voted to leave the European Union (EU). The original deadline of March 29th has been extended to April 12th. As the new deadline approaches, the odds are that a new one will be negotiated, probably by the May 23rd EU elections or even later. The imbroglio has been highly complex, even for the most astute of political analysts. However, our simple observation is that while the pound is sitting exactly where it was after the 2016 referendum results, the odds of a hard Brexit have significantly fallen since then. We are opening a buy-stop on GBP/USD at 1.30 today for a trade (Chart I-7). A very detailed scenario analysis for Brexit was discussed in this month’s Bank Credit Analyst publication.2 The historical context is that while complete sovereignty of a nation is and always has been a desirable fundamental right, a hard Brexit will do little to alleviate the British voters’ angst. Globalization, decades of supply-side reforms and competition from emerging markets have lifted income inequality in the U.K. to the detriment of the average U.K. voter. However, this is hardly due to European integration, given that this same sentiment afflicts many other independent nations. Economic surprises in the U.K. relative to both the U.S. and euro area are soaring.  Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard Brexit. Meanwhile, there is scant evidence the general populace wanted a hard Brexit, given the very slim margin of victory for the Leave vote. It is also possible that absent the prominence of migration issues and terrorist attacks that were afflicting Europe at the time, we would not be having this debate today. Chart I-7Changing Landscape For The Pound Changing Landscape For The Pound Changing Landscape For The Pound Chart I-8What Brexit? What Brexit? What Brexit?     As we publish this week, British Prime Minister Theresa May has kicked off negotiations with opposition party leader Jeremy Corbyn in a plan to muster a deal before the April 12th deadline. This falls into the first camp of our three scenarios, which are: 1) a softer Brexit deal; 2) a general election to break the impasse; or 3) another referendum. In the case of a general election, unless a hard Tory replaces Ms. May, chances are a softer Brexit will prevail. Meanwhile, our geopolitical strategists have ventured to say that Brexit is unsustainable over the secular horizon, and that the U.K. will remain in the EU. Bottom Line: While the political battle unfolds in the U.K., the reality is that the pound and U.K. gilt yields should be much higher solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-8). Economic surprises in the U.K. relative to both the U.S. and euro area are soaring. With the benefit of hindsight, it is possible cable made its lows in mid-2016-early 2017 as it became clearer that the probability of a hard Brexit was waning. We are placing a limit buy on the pound today at 1.30, with a wide stop at 1.22. Buy AUD/NZD Chart I-9AUD Is On Sale AUD Is On Sale AUD Is On Sale There are few times in markets and trading when you get a semblance of a free lunch. But one such opportunity may be on the table for the Aussie versus the Kiwi. For starters, over the past five years or so, whenever this cross has broken below the 1.04 support level, going long proved to be a profitable strategy over the ensuing 6-to-12 months. Meanwhile, over the last 35 years, the cross has spent more than 95% of the time over 1.06, with the low in 2015 close to parity. Finally, the cross is very cheap on a real effective exchange rate basis, which means that relative prices in Australia are at a discount to those in New Zealand (Chart I-9).  The confluence of monetary policy shifts over the last few months may be blurring the direction of relative interest rate trends, but on the simple basis of real three-month interest rate differentials, the Aussie should be 15% higher relative to the Kiwi (Chart I-10). Ever since 2015, the market has been significantly more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. We may now be entering a window where economic data in New Zealand converges to the downside relative to Australia, the catalyst being a foreign ban on domestic house purchases (Chart I-11). Chart I-10Divergences Are Very Rare Divergences Are Very Rare Divergences Are Very Rare Chart I-11Australia Is Well Along The Adjustment Path Australia Is Well Along The Adjustment Path Australia Is Well Along The Adjustment Path Chart I-12Domestic Demand Pressures In New Zealand Domestic Demand Pressures In New Zealand Domestic Demand Pressures In New Zealand A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is 0.22%.3 However, the housing wealth effect is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. According to their calculations, the housing wealth elasticity for consumption is 0.23 for negative shocks, as compared to 0.13 for positive changes in housing wealth. This asymmetry may be due to the fact that, at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. The study proves timely, since the RBNZ began a new mandate on April 1st to now include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Falling consumption will depress aggregate demand which, in turn, will depress consumption further. Falling inbound migration levels at a time of rapidly dwindling labor supply everywhere means the goldilocks scenario of non-inflationary growth may be behind us (Chart I-12). And for an economy driven by agricultural exports, productivity gains will be hard to come by. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock, and evidence is rising that this is turning in favor of the Aussie (Chart I-13). China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-14). Given that eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. Australia overtook Qatar last year as the world’s biggest exporter of liquefied natural gas. As the market becomes more liberalized and long-term contracts are revised to reflect surging spot prices, the Aussie dollar will get a boost. Chart I-13A Positive Shift A Positive Shift A Positive Shift Chart I-14A Shifting Export Landscape A Shifting Export Landscape A Shifting Export Landscape   Bottom Line: Go long AUD/NZD as a strategic position. Place stops at parity.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Into A Transition Phase,”dated March 8, 2019, available at fes.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report, titled “The State Of Brexit,” dated March 28, 2019, available at bca.bcaresearch.com 3 Mairead de Roiste, Apostolos Fasianos, Robert Kirkby, and Fang Yao, “Household Leverage and Asymmetric Housing Wealth Effects - Evidence from New Zealand,” Reserve Bank of New Zealand, Discussion Paper Series, (April 2019). Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been weak compared to the rest of the world: Retail sales in February contracted by 0.2% month-on-month, shy of consensus of 0.3%. The March Markit manufacturing PMI fell  to 52.4 while ISM manufacturing PMI rose to 55.3. However, the ISM non-manufacturing PMI also decreased to 56.1. The February durable goods orders contracted by 1.6% while still better than expected. Initial jobless claims fell to 202k this week. DXY index initially fell by 0.3% before rebounding to end the week flat. The upbeat Chinese data earlier this week was the strongest in the manufacturing sector for the past 8 months. Easing financial conditions worldwide and progress on trade talks have brought back investors’ risk appetite, which is a headwind for the counter-cyclical dollar. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have shown tentative signs of a recovery: The Markit manufacturing PMI fell to 47.5 in March, the weakest number since 2013. However, the Markit composite PMI and services PMI increased to 51.6 and 53.3 respectively, both higher than expected. The unemployment rate stayed unchanged at 7.8% in February. Consumer price inflation in March fell slightly to 1.4%. Retail sales grew at 2.8% year-on-year in February, outperforming expectations of 2.3% growth. In Germany, retail sales surged by 4.7% year-on-year. EUR/USD depreciated by 0.2% this week. While the manufacturing data remains weak, the services PMI and retail sales in the euro area all show signs of an imminent pickup. During a speech last Wednesday, Mario Draghi highlighted that policy will continue to remain accommodative which should help financial conditions. Moreover, good news from U.K. and China could improve the trade outlook in the euro area. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been positive: Housing starts in February grew by 4.2% year-on-year. Nikkei manufacturing PMI in March came in at 49.2, surprising to the upside, while the services PMI fell slightly to 52. Foreign investment in Japanese stocks increased to 438.7 billion yen. USD/JPY appreciated by 0.5% this week. The Tankan survey for Q1 was a bit disappointing, but nascent green shoots in the global economic recovery are providing support for Japanese shares. On the flip side, the higher risk appetite will likely decrease the demand for the safe-haven Japanese yen. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: The Q4 GDP surprised to the upside, coming in at 1.4% year-on-year. The Markit manufacturing PMI jumped to 55.1 in March, the strongest within the past year. The Markit construction PMI came in slightly below expectation at 49.7, while still above the last reading of 49.5. The services PMI fell to 48.9.  GBP/USD appreciated by 0.7% this week. GBP/USD has been very volatile over the past weeks amid ongoing Brexit uncertainties. Despite this, the U.K. economy has been very healthy and cable is still trading at a discount to its fair value. Report Links: A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been improving: The NAB business confidence fell to 0 in March, but the business conditions component increased to 7. The February HIA new home sales increased by 1% month-on-month. Building permits in February increased by 19.1% month-on-month. Retail sales increased by 0.8% month-on-month in February. Trade balance came in at 4.8 million AUD in February. Legacy LNG projects almost guarantee trade surpluses for years to come. AUD/USD has been flat this week. On Tuesday, the RBA kept the interest rate unchanged at 1.5%, as was widely expected. AUD/USD is likely to form a floor if Chinese economic activity continues to improve and global industrial production picks up. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: The global dairy trade price index increased by 0.8% in April.  ANZ commodity prices increased by 1.4% in March. NZD/USD fell by 1% this week. Despite positive terms of trade, NZD/USD is still trading at a 10%-15% premium above its fair value. New Zealand will be held hostage to the downturn in the Aussie economy. Meanwhile, a new dual mandate for the RBNZ makes it difficult to gauge whether its recent dovish shift is a one-off or more perpetual. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: GDP grew by 0.3% month-on-month in January, surprising to the upside. However, the Markit manufacturing PMI fell to 50.5 in March, from a previous reading of 52.8. USD/CAD rebounded after the plunge on positive Canadian GDP data, returning flat this week. On Monday, Governor Poloz gave a speech in Nunavut, highlighting slowing trade growth and the downside risks from trade wars. He stated that the economic outlook continues to warrant a policy rate that is well below the neutral range, and trade among provinces and territories should be promoted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been strong: The KOF leading indicator increased to 97.4 in March. The February retail sales growth came in at -0.2% year-on-year, above the estimated -0.8%. Consumer price index came in higher than expected at 0.7% year-on-year. USD/CHF increased by 0.47% this week. While the inflation rate took a step closer towards the target rate, the uptick in investment sentiment and rising appetite for risk assets could be a headwind for the safe-haven franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been improving: Retail sales contracted by 1.3% month-on-month in February. However, the registered unemployment fell to 78.32k in March. The unemployment rate decreased to 2.4% accordingly. House prices increased by 3.2% year-on-year in March. The manufacturing PMI rose from 56.3 to 56.8 in March. USD/NOK fell by 0.3% this week. The Norwegian krone has been one of our favorite currencies, as it remains most responsive to crude oil prices. Our BCA house view is in favor of rising oil prices amid Iran and Venezuela sanctions and production cuts. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been better than expected: The manufacturing PMI came in at 52.8 in March, slightly higher than 52.7 in February. USD/SEK has been flat this week. The Swedish krona is still trading below its one sigma band of fair value. A brighter picture for the euro area could improve trade conditions for Sweden. Our short USD/SEK position is now 1.84% in the money since initiated. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The meaningful improvement in the March manufacturing PMIs (both Caixin and official) all but confirms that a rebound in Chinese economic activity is forthcoming. The odds that investors will look through any near-term economic and/or earnings weakness are directly related to the likely magnitude of the expansion in credit over the coming year, and our research points to the need for the recent pace of credit growth to be sustained in order to stabilize the outlook for earnings. Barring a substantial breakdown in trade talks between China and the U.S., a strong March total social financing release would likely tip the scales in favor of a recommendation to increase Chinese investable stock exposure within a global equity portfolio to overweight. Feature Tables 1 and 2 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident economic activity has sharply converged with our leading indicator for China’s economy, which we highlighted was likely to occur. Looking forward, while we await the March total social financing release later this month for a better sense of the likely magnitude in credit growth over the coming year, the meaningful improvement in the March manufacturing PMIs (both Caixin and official) all but confirms that a rebound in Chinese economic activity is forthcoming. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review ​​​​​​​ The likely magnitude of the uptrend in credit is important from an investment strategy perspective, as we have highlighted that weak coincident activity raises the risk of a lagged but meaningful further decline in Chinese earnings per share over the coming few months. The odds that investors will look through any near-term economic and/or earnings weakness are directly related to the ultimate size of the expansion in credit, and our research points to the need for the recent pace of credit growth to be sustained in order to stabilize the outlook for earnings. But the bottom line for investors is that we recently placed Chinese investable stocks (i.e. the MSCI China Index) on upgrade watch, and the March PMI is a step in the direction of a recommendation to increase equity allocation to overweight within a global stock portfolio. Investors should closely watch the March total social financing data (due to be released in mid-April); a strong release, barring a substantial breakdown in trade talks between China and the U.S., would likely tip the scales in favor of a move to overweight. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Chart 1 shows that coincident economic activity sharply converged in January and February with our leading indicator for China’s economy, as we had argued many times over the past several months was likely to occur. In our view, most if not all of the previously beneficial tariff front-running effect has probably washed out of the data, implying that future changes in activity measures are now more likely to reflect actual changes in underlying economic circumstances. Chart 1A Convergence That We Predicted A Convergence That We Predicted A Convergence That We Predicted The components of our LKI leading indicator continue to point to divergent outcomes for the Chinese economy (Chart 2). Monetary conditions have weakened somewhat over the past few months, but remain quite easy relative to history. The credit components bounced in January but are still weak relative to their history, whereas money growth is extremely weak and has shown no sign of improvement. Barring a major rise in the RMB, a continuation in the recent pace of credit growth would likely be enough to cause our leading indicator to trend higher, particularly if money growth begins to pick up. Chart 2An Uptrend In Credit Growth Will Push Our Leading Indicator Higher An Uptrend In Credit Growth Will Push Our Leading Indicator Higher An Uptrend In Credit Growth Will Push Our Leading Indicator Higher We noted in our March 13 Weekly Report that growth in residential floor space started was unsustainably strong,1 and the January/February data update confirmed this view. Growth in starts has decelerated by 10 percentage points from December to February, highlighting that housing construction cannot permanently decouple from sales volume and that a further deceleration is possible unless sales growth (which is currently negative) begins to pick up. The PMI rebound in March registers as one of the most important macro developments since the release of the January total social financing data. Both the Caixin and official manufacturing PMI data came in solidly positive for March, rising relative to their February values and surprising consensus expectations to the upside. Chart 3 highlights that the March Caixin data has pushed the series above its post-2010 median, whereas the official PMI has risen to its 40th percentile from essentially its lowest point in the past decade. In our view, the PMI rebound registers as one of the most important macro developments since the release of the January total social financing data, in that it all but confirms that a rebound in (still depressed) Chinese economic activity is forthcoming. Chart 3A Very Sharp Rebound In Both Manufacturing PMIs A Very Sharp Rebound In Both Manufacturing PMIs A Very Sharp Rebound In Both Manufacturing PMIs Despite having rallied significantly from their low, Chinese stocks (both investable and domestic) remain approximately 20% below their early-2018 high in US$ terms. This is in contrast to global stocks, which are only 7% shy of their 2018 high. If Chinese equities can avoid a major earnings recession, this discrepancy underscores that there is further upside for stock prices in relative terms over the coming 6-12 months. For the A-share market, however, Chart 4 highlights a potential near-term roadblock for continued outperformance versus global stocks. The chart highlights that the relative performance trend is now bumping up against the upper end of a declining trend channel that has been in place for almost 4 years, a bearish pattern that is in stark contrast to that of the investable market. Conversely, a break outside of this channel would warrant attention, as it could signal a secular change in trend for the domestic equity market. Chart 4Is The Four Year Downtrend In A-Share Relative Performance Over? Is The Four Year Downtrend In A-Share Relative Performance Over? Is The Four Year Downtrend In A-Share Relative Performance Over? Chart 5 highlights that the strange combination of consumer staples and real estate stocks have been the clear sector winners over the past month, both in the investable and domestic markets. Signs of stabilization in consumer spending explains staples outperformance, but the rally in real estate stocks is more difficult to explain given the weakness in housing fundamentals referenced above. For now, our bias is to believe that real estate stocks are benefitting as a value play, given their deep discount relative to both their respective broad markets and their global peers. Chart 5A Sharp Rebound In Staples And Real Estate Stocks A Sharp Rebound In Staples And Real Estate Stocks A Sharp Rebound In Staples And Real Estate Stocks China’s 7-day interbank repo rate has increased somewhat over the past month, raising speculation that the PBOC may soon proceed with a generalized cut to the reserve requirement ratio. In our view, the trend in the 3-month interbank repo rate has been more important over the past few years, as it has closely correlated since late-2016 with average interest rates in the economy and sharp declines in the rate last year preceded the pickup in credit growth observed in January. Still, additional easing from the PBOC could be significant for market participants, as it would likely be greeted positively by investors and could further stoke the belief that Chinese credit growth may overshoot to the upside over the coming 6-12 months. A stronger RMB versus the euro will be welcome news for European exporters. In contrast to a significant improvement in domestic equity prices and investor sentiment, Chinese onshore corporate bond spreads have actually inched higher over the past month. While the rise has been comparatively small (8 basis points), spreads now stand at roughly a third of their 12-month range. A rising trend in onshore corporate bond spreads is not consistent with a slower pace of defaults over the coming 6-12 months, suggesting that at least some headwinds facing the Chinese economy will remain over the coming year if the recent trend in spreads continues. While CNY-USD has been largely flat over the past month, CNY-EUR has continued to rise and is now within striking distance of its 2018 high (Chart 6). This is not likely welcome news for Chinese exporters with close ties to Europe, but it may help provide a much-needed trade boost to the European economy over the coming year, whose manufacturing PMI has recently fallen to a six-year low. Chart 6A Stronger CNY-EUR Cross Will Help Boost Chinese Imports From Europe A Stronger CNY-EUR Cross Will Help Boost Chinese Imports From Europe A Stronger CNY-EUR Cross Will Help Boost Chinese Imports From Europe   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China Macro And Market Review”, dated March 13, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Meanwhile, history suggests that the trade-weighted dollar should have been 10-15% higher, based on portfolio flows and interest rate differentials. The more-muted bounce is a cause for concern. As the battle unfolds, likely winners in the interim will be safe-haven currencies such as the yen. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. We expect a day of reckoning to eventually arrive for the U.S. dollar, once investors shift their focus towards the rising twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets. Feature The recent calm in developed currency markets seems very eerie, given the storm that has gripped global financial markets over the past week. Dismal manufacturing PMI readings from Europe and Japan last week sent equity markets into a tailspin. The closely watched U.S. 10-year versus 3-month spread inverted, triggering panic selling among investors who favor this spread as their most reliable recession indicator. Equity markets in Asia are off the year’s highs, while regional bond yields are holding close to trading lows. Outside of oil, commodity markets have also been soft. Despite these moves, the trade-weighted dollar has been relatively stable. Over the last few months, most currency pairs have been narrowly trading towards the apex of very tight wedge formations. This has severely dampened volatility (Chart 1). Over the longer term, the stability of these crosses relative to gold has spooky echoes of a fixed exchange rate regime a la Bretton Woods (Chart 2). Chart 1An Eerie Calm In Currency Markets An Eerie Calm In Currency Markets An Eerie Calm In Currency Markets Chart 2Fixed Exchange Rates Versus Gold? Fixed Exchange Rates Versus Gold? Fixed Exchange Rates Versus Gold?   In physics, centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. This means constantly monitoring both the trend and magnitude of imbalances between economies to gauge where the pressure points are, and in what direction the corresponding exchange rates might eventually give way. The balance of forces driving the dollar outlook seems like a natural starting point for this exercise.  Global Liquidity And The Dollar Judging by most measures of relative trends, the dollar should be soaring right now. The March Markit manufacturing PMI releases last week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.5 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such large growth divergences between the U.S. and the rest of the world have generated anywhere from 10-15% rallies in the greenback over a period of six months (Chart 3). So far, the DXY dollar index is up 1.9% since October. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere. Until the U.S. Federal Reserve’s recent volte-face on monetary policy, relative yields also favored the greenback. The 2-year swap differential between the U.S. and the rest of the world pinned the DXY dollar index at 105, or 8% above current levels (Chart 4). Meanwhile, relative policy rates also suggest the broad trade-weighted dollar should be 6% higher. And even today, unless the Fed moves towards outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. Chart 3USD Should Be Higher Based On Growth Divergences USD Should Be Higher Based On Growth Divergences USD Should Be Higher Based On Growth Divergences   Chart 4USD Should Be Higher Based On Swap Differentials USD Should Be Higher Based On Swap Differentials USD Should Be Higher Based On Swap Differentials   Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling ever since. This has triggered a severe contraction in the U.S. monetary base (Chart 5), and severely curtailed commercial banks’ excess reserves, which are now contracting by over 20% on a year-on-year basis. One of BCA’s favorite key measures of international liquidity is foreign central bank reserves deposited at the Fed. This is contracting at its worst pace in over 40 years. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere, typically among countries running twin deficits. Chart 5A Liquidity Squeeze Of Dollars A Liquidity Squeeze Of Dollars A Liquidity Squeeze Of Dollars To cap it off, last year’s change in the U.S. tax code to allow for repatriation of offshore cash helped the dollar, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated back a net of about $US400 billion in assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher (Chart 6). Chart 6USD Should Be Higher On Repatriation Flows USD Should Be Higher On Repatriation Flows USD Should Be Higher On Repatriation Flows Dollar liquidity shortages tend to be vicious due to their ability to trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending and consumption once this reaches a critical threshold. The drop in output, prices, or a combination of the two, only exacerbates the debt-deflation problem.  The bottom line is that looking at historical trends, the dollar should be much higher than current levels. Practical investors recognize the need to pay heed to correlation shifts. Either our favorite liquidity indicators have stopped working outright or more realistically other forces are at play, explaining the relative stability in the greenback. A Counter-Cyclical Currency The first possibility is that the recent stability in the U.S. dollar has been in anticipation of better economic data in the second half of this year. We have shown many times in the past that the greenback is a countercyclical currency that tends to do poorly when global economic momentum picks up. Many investors are now fixated on China – specifically, whether the latest credit injection will be sufficient to turn around the Chinese economy, let alone the rest of the world. Meanwhile, as the U.S.-China trade talks progress, it will likely include a currency clause to prevent depreciation of the RMB versus the dollar. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability.  In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. Typical reflation indicators such as commodity prices, emerging market currencies and industrial share prices are off their lows but rolling over. March export data remained weak globally, even though compositionally there were some green shoots. Exports to China from Singapore jumped by 34% year-on-year, and those to emerging markets by 22% year-on-year. Japanese machine tool orders from China also showed some stabilization. Historically, these are necessary but not sufficient conditions to gauge whether we are entering a bottoming process (Chart 7). Another contradiction is at play: If the dollar rally is being held back by prospects of improvement in global growth, then gold should fare poorly and most currencies should be outperforming both gold and the greenback. Until yesterday’s sell off in gold, this was not the case. Suggesting some other explanation might be tempering the U.S. dollar’s rise. Chart 7Tentative Green Shoots In Global Trade? Tentative Green Shoots In Global Trade? Tentative Green Shoots In Global Trade?   Regime Shift? While U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. capital markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart 8). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of about $450 billion in U.S. securities, but the downtrend in purchases in recent years is evident. Interestingly, gold has also outperformed Treasurys over this period. The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges. Vis-à-vis official flows, China has risen within the ranks to be the number one contributor to the U.S. trade deficit. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB (Chart 9). In a broader sense, the fall in dollar deposits at the Fed might just represent an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Chart 8Foreigners Are Dumping U.S. Equities Foreigners Are Dumping U.S. Equities Foreigners Are Dumping U.S. Equities   Chart 9China Has Stopped Recycling Surpluses Into Treasurys China Has Stopped Recycling Surpluses Into Treasurys China Has Stopped Recycling Surpluses Into Treasurys   Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, notably the British pound, Swiss franc and the yen have been surging (Chart 10). At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 11). This further helps explain why the dollar may not be as strong as it should be. It also explains the stability of these currency pairs relative to the price of gold. Chart 10The World Is Diversifying Away From Dollars The World Is Diversifying Away From Dollars The World Is Diversifying Away From Dollars Chart 11Central Banks Are Absorbing Most Gold Production Central Banks Are Absorbing Most Gold Production Central Banks Are Absorbing Most Gold Production The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.5% of GDP. Assuming the current account deficit widens a bit then stabilizes, this will pin the twin deficits at 8.1% of GDP. This assumes no recession, which would have the potential to swell the deficit even further (Chart 12). Chart 12A Twin Deficit Cliff For The Dollar A Twin Deficit Cliff For The Dollar A Twin Deficit Cliff For The Dollar The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the U.S. trade deficit. Shale productivity remains robust and U.S. output will continue to rise, but the low-hanging fruit has already been plucked. For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising U.S. twin deficits, this will continue as well. And if the U.S. dollar cannot sufficiently rally on “good news,” expect it to sink when the bad news eventually starts rolling in. That said, the timing remains uncertain.   Private Capital Flows Foreign official flows might have been fleeing the U.S. dollar because it has lost some luster as a reserve currency, but private capital will begin stampeding toward the exits when the return on invested capital (ROIC) for U.S. assets falls below their cost of capital. For investors with a long horizon, this may already be happening. Take 10-year government bonds for example. For the Japanese or German investor, borrowing in local currency and investing in the U.S. might seem like the logical course of action given negative domestic rates and a 10-year Treasury yield of 2.4%. However, this positive carry suddenly evaporates when one factors in hedging costs (Chart 13). Chart 13JGBs More Attractive Than Hedged Treasuries JGBs More Attractive Than Hedged Treasuries JGBs More Attractive Than Hedged Treasuries During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. With many yield curves around the world inverting, the danger is that the frequency of this short-covering implicitly rises, since long-bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen. Investors should consider initiating short USD/JPY positions today as a hedge. Outside the fixed-income space, what matters is that relative ROICs are higher than the cost of capital. Both are difficult to measure for many emerging or even developed economies across asset classes. However, for the equity market, a good starting point has always been valuations as exchange rates tend to move to equalize returns across countries. The forward P/E on the MSCI U.S., Europe and Japan indexes is 16.5x, 12.6x and 12.3x. The skew towards the U.S. is because market participants expect U.S. profits to keep outperforming, the U.S. currency to keep appreciating, or a combination of the two. However, empirically, current U.S. valuations suggest future earning streams have already been fully capitalized today (Chart 14). Chart 14AReturn On Capital Could Be Lowest In The U.S. (1) Return On Capital Could Be Lowest In The U.S. (1) Return On Capital Could Be Lowest In The U.S. (1) Chart 14BReturn On Capital Could Be Lowest In The U.S. (2) Return On Capital Could Be Lowest In The U.S. (2) Return On Capital Could Be Lowest In The U.S. (2) Chart 14CReturn On Capital Could Be Lowest In The U.S. (3) Return On Capital Could Be Lowest In The U.S. (3) Return On Capital Could Be Lowest In The U.S. (3) The expected 10-year annualized return for MSCI U.S. is 3.1%, versus 5.5% for MSCI Europe and 9.6% for MSCI Japan. If we assume the U.S. dollar is overvalued, as some models suggest, this will further erode future U.S. returns. Net equity portfolio flows into the U.S. are already negative, as shown in a previous chart. This means the day of reckoning for the U.S. dollar may not be far off when current tailwinds eventually fade.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades