Currencies

Highlights Global equities and other risk assets will trade sideways with elevated volatility over the coming weeks before grinding higher for the remainder of the year, as global growth finally accelerates after a series of false starts.  We now see the Fed raising rates more slowly than we had previously envisioned, but ultimately having to scramble to hike rates in order to quell inflation. The fed funds rate will probably plateau at 4% in 2021, implying nine quarter-point hikes more than the market is currently discounting.   Over a 12-month horizon, investors should overweight global equities, underweight government bonds, and maintain a neutral allocation to cash. The dollar will peak in the second quarter and then weaken over the remainder of the year and into 2020, before starting to strengthen again late next year. Investors should prepare to temporarily upgrade EM and European stocks over the coming weeks, while increasing exposure to cyclical equity sectors. Industrial metals and oil will strengthen over the course of the year. Gold should be bought on any dip. Investors should begin to de-risk their portfolios in late-2020 in anticipation of a recession in 2021. Chart 001   Feature Here We Go Again? After having become more defensive last June, we turned bullish on stocks following the December post-FOMC meeting plunge. As stocks continued to rebound, we tempered our optimism. In the beginning of March, we wrote that “having rallied since the start of the year, global stocks will likely enter a ‘dead zone’ over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout.”1 Last Friday’s release of disappointing European PMI data poured some herbicide on the green shoots thesis. Germany’s manufacturing PMI hit a six-year low, with the new orders component registering the weakest reading since the Great Recession. This took the 10-year German bund yield into negative territory for the first time since 2016. The U.S. 10-year Treasury yield also fell to a 15-month low, causing the 3-month/10-year curve to invert. Historically, an inverted yield curve has been a reliable predictor of U.S. recessions (Chart 1). Chart 1Yield Curve Inversions, Recessions, And The Term Premium Yield Curve Inversions, Recessions, And The Term Premium Yield Curve Inversions, Recessions, And The Term Premium President Trump’s decision to appoint TV commentator Stephen Moore to the Fed’s Board of Governors did not help matters. Recommended by fellow supply-side “economist” Larry Kudlow, Moore is best known for dismissing concerns over the state of the housing market in 2007, his spot-on 2010 prediction that QE would cause hyperinflation, and his belief that the Trump tax cuts would lead to a smaller budget deficit. Global Growth Will Accelerate In The Second Half Of The Year Given all these worrisome developments, is it time to turn cyclically bearish on the economic outlook and risk assets again? We do not think so. While the next few weeks could be challenging for equities – a risk that our MacroQuant model is currently flagging – sentiment should improve as global growth finally accelerates after a series of false starts.  Indeed, some positive signs are already visible: The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has moved higher (Chart 2). It leads the global LEI. Service sector PMIs have also generally improved, suggesting that the weakness in global growth remains concentrated in trade and manufacturing. And even on the trade front, a few forward-looking indicators such as the Baltic Dry Index and the weekly Harpex shipping index, which measures global container shipping activity, have bounced off their lows. We would downplay the signal from the yield curve, as it currently is severely distorted by a negative term premium. If the 10-year Treasury term premium were back to where it was in 2004, the 3-month/10-year slope would be more than 200 bps steeper, and nobody would be talking about this issue. In fact, given today’s term premium, the curve would have almost certainly inverted in 1995. Anyone who got out of stocks back then would have missed out on one of the greatest bull markets in history. It should also go without saying that some of the decline in the U.S. 10-year yield reflects a positive development: The Fed has turned more dovish! If one looks at the 10-year/30-year portion of the yield curve, it has actually steepened. This is a sign that the market is seeing the Fed’s actions as being reflationary in nature. There is no clear causal mechanism by which an inverted yield curve slows economic activity, apart from it potentially becoming a self-fulfilling prophecy where the yield-curve inversion scares investors, thereby leading to a tightening in financial conditions (Chart 3). Such “doom loops” are conceptually possible, but as we discussed earlier this year, they are unlikely to occur in the current environment.2 At any rate, financial conditions have eased since the start of the year. This should boost growth in the coming months.   Chart 2Global Growth May Be ##br##Starting To Stabilize Global Growth May Be Starting To Stabilize Global Growth May Be Starting To Stabilize Chart 3Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Chinese Credit Growth Set To Rise Global growth has been weighed down by a slowing Chinese economy. Last year’s deleveraging campaign led to a significant deceleration in investment spending, which had negative repercussions for capital equipment and commodity producers all over the world (Chart 4). Historically, China has loosened the reins on the financial sector whenever credit growth has fallen towards nominal GDP growth (Chart 5). It appears we have reached this point. Despite a weak seasonally-distorted February print, credit growth has finally accelerated on a year-over-year basis. Chart 4China: The Deleveraging Campaign Had Adverse Effects On Investment Spending China: The Deleveraging Campaign Had Adverse Effects On Investment Spending China: The Deleveraging Campaign Had Adverse Effects On Investment Spending Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth We do not expect Chinese credit growth to rise as much as in past releveraging cycles. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 6).3 As long as the central government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. In any case, given that total debt stands at 240% of GDP, even a one percentage-point increase in credit growth would generate a hefty 2.4% of GDP in credit stimulus. The Chinese credit impulse leads imports by about six-to-nine months (Chart 7). This bodes well for global trade in the second half of the year. Chart 6China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth Chart 7Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse   A Lull In The Trade War? A de-escalation in the trade war would help matters. As a self-professed master negotiator, Donald Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the agreement was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky for Trump if it had failed to bring down the bilateral trade deficit – an entirely likely outcome given how pro-cyclical U.S. fiscal policy is. At this point, however, Trump could crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized only after he has been re-elected. Thus, the likelihood that Trump will seek to strike a deal has risen. For their part, the Chinese want as much negotiating leverage as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Faster Global Growth And Stronger Domestic Demand Will Benefit Europe Stronger Chinese growth will help the European export sector later this year. The export component of the Chinese Caixin PMI has moved up from its lows. It leads the euro area PMI by about three months. Meanwhile, euro area domestic demand will benefit from a more accommodative fiscal policy and lower bond yields. The decline in bond yields will be especially helpful to Italy. The spike in yields and loss of business confidence following the election of a populist government last March plunged the economy into recession (Chart 8). Now that the 10-year BTP yield has fallen more than 100 bps from its highs, the Italian economy should start to perk up. The ECB will not raise rates this year even if domestic growth speeds up, but the market will probably price in a few rate hikes in 2020 and beyond. This will allow for a modest re-steepening of yield curves in core European bond markets, which should be positive for long-suffering bank profits. Brexit remains a concern. The ongoing saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 9), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 8Italian Bond Yields Are A Headwind No More Italian Bond Yields Are A Headwind No More Italian Bond Yields Are A Headwind No More Chart 9U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win   What Will The Fed Do? Chart 10 Last year’s “Christmas Crash” clearly shifted the Fed’s reaction function in a more dovish direction. We do not expect Jay Powell to raise rates over the next few months, but a reacceleration in global growth is likely to prompt the Fed to tighten anew in December. The Fed will continue raising rates once per quarter in 2020, before accelerating the pace of tightening in 2021 in response to rising inflation. In all, we see the fed funds rate increasing to around 4% by the end of this cycle. This represents nine quarter-point hikes more than the market is currently discounting (Chart 10). We were stopped out of our short fed funds futures trade, but we recommend that clients short the June-2021 fed funds futures or a similar instrument. The U.S. Economy: Great Again Fundamentally, the U.S. economy is on solid ground and can handle higher interest rates. Unlike a decade ago, the housing market is in good shape (Chart 11). The homeowner vacancy rate stands near a record low. Judging by FICO scores, the quality of mortgage lending remains high. The labor market is also firm, with job openings hitting another record high in February (Chart 12). The combination of a healthy housing and labor market is invariably good for consumers. Chart 11U.S. Housing Fundamentals Are Solid U.S. Housing Fundamentals Are Solid U.S. Housing Fundamentals Are Solid Chart 12The U.S. Labor Market Is Firm The U.S. Labor Market Is Firm The U.S. Labor Market Is Firm Chart 13 The personal savings rate currently stands at 7.6%, notably higher than one would expect based on the ratio of household net worth-to-disposable income (Chart 13). A decline in the savings rate would allow consumer spending to increase more quickly than income. With the latter being propped up by rising wages, this will be bullish for consumption. Capital spending intentions have dipped over the past few months, but remain elevated by historic standards (Chart 14). The real nonresidential capital stock has grown by an average of only 1.7% since the start of the recovery, down from 3% in the pre-recession period (Chart 15). A cyclical upswing in productivity growth, rising labor costs, and low levels of spare capacity should all motivate businesses to invest in new plant and equipment. Chart 14Capital Spending Intentions Have Softened, But Remain Elevated Capital Spending Intentions Have Softened, But Remain Elevated Capital Spending Intentions Have Softened, But Remain Elevated Chart 15There Is Room For More U.S. Capital Investment There Is Room For More U.S. Capital Investment There Is Room For More U.S. Capital Investment   Corporate Debt: How Much Of A Risk? Chart 16U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards Corporate debt levels have increased significantly in recent years, while underwriting standards have deteriorated, as evidenced by the proliferation of covenant-lite loans. Nevertheless, the situation is far from dire. Relative to other countries, U.S. corporate debt is quite low (Chart 16). At 143% of GDP, corporate debt in France is twice that of the United States. This is not to suggest that everything is fine in the French corporate sector; but the fact is that France has not had a corporate debt crisis. This signals that the U.S. is not at imminent risk of one either. Netting out cash, U.S. corporate debt as a share of GDP is at the same level it was in 1989, a year in which the fed funds rate was close to nine percent. The ratio of corporate net debt-to-EBITD remains reasonably low. The interest coverage ratio is above its historic average. In addition, corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 17). The corporate sector financial balance – the difference between corporate income and spending – is still in positive territory at 1% of GDP. Every recession in the past 50 years began when the corporate sector financial balance was in deficit (Chart 18). Chart 17U.S. Corporate Debt: How High? U.S. Corporate Debt: How High? U.S. Corporate Debt: How High? Chart 18Corporate Sector Financial Balance Still In Surplus Corporate Sector Financial Balance Still In Surplus Corporate Sector Financial Balance Still In Surplus Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players such as pension funds, insurance companies, mutual funds, and ETFs. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 19). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 20). This makes corporate debt less systemically important for the economy.   Chart 19Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Chart 20U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized One of the reasons we turned more bullish on risk assets in December was because stocks had plunged and corporate spreads widened without much follow-through in financial stress indices. For example, the infamous TED spread barely budged (Chart 21). Chart 21TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress Everyone Agrees With Larry Given the lack of major imbalances in the U.S. economy, why do investors believe that the Fed cannot raise rates further even though the Fed funds rate in real terms is barely above zero? The answer is that investors appear to have bought into Larry Summers’ secular stagnation thesis, which posits that the neutral rate of interest is much lower today than it was in the past. We have some sympathy for this thesis, but it is important to remember that it is a theory about the long-term determinants of interest rates such as productivity and demographic trends. The theory says little about the cyclical drivers of interest rates, including the amount of spare capacity in the economy, the stance of fiscal policy, credit growth, and wage trends. Earlier this decade, when we were still very bullish on bonds, one could have plausibly argued that the economy needed extremely low interest rates: The output gap was still large; the deleveraging cycle had just begun; home and equity prices were depressed; wage growth was anemic; and fiscal policy had turned restrictive after a brief burst of stimulus during the Great Recession. Far From Neutral? All of the forces mentioned above have either fully or partially reversed course over the past few years. Take fiscal policy as one example. The IMF estimates that the U.S. structural budget deficit averaged 3.3% of GDP in 2014-15. In 2019-20, the IMF reckons the deficit will average 5.6% of GDP. To what extent has easier fiscal policy raised the U.S. neutral rate of interest? Let us conservatively assume that every $1 of additional fiscal stimulus adds $1 to aggregate demand. In this case, fiscal policy has added 2.3% of GDP to aggregate demand over the past five years. Suppose that a one-percentage point increase in aggregate demand raises the neutral rate of interest by 1%, which is in line with the specification of the Taylor Rule that former Fed Chair Janet Yellen favored. This implies that fiscal policy alone has raised the neutral rate by over two percentage points. The discussion above suggests that cyclical factors may have pushed up the neutral rate considerably, even if long-term structural factors are still dragging it down. Since the Fed is supposed to set interest rates with an eye on what is appropriate for the economy over the next year or two, rates may end up staying too low for too long. This will cause the economy to overheat, eventually leading to a surge in inflation. The Inflation Boogeyman The good news is that none of our favorite indicators point to a major imminent inflationary upswing (Chart 22): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s proprietary Pipeline Inflation Indicator has fallen to a two-and-a-half-year low. Wage growth has accelerated, but productivity growth has increased by even more. As a result, unit labor cost inflation has been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 23). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 22No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... Chart 23... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being At that point, risks are high that inflation will move up. This could force the Fed to start raising rates aggressively in early-2021, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in mid-to-late 2021.   Stay Bullish Global Equities For Now, Turn Defensive Late Next Year Chart 24Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted The two-stage Fed tightening cycle discussed above – gradual rate hikes starting in December and continuing into 2020, and more aggressive hikes thereafter in response to rising inflation – shapes our investment views over the next few years. The Key Financial Market Forecasts Chart at the beginning of this publication provides a rough sketch of where we think the main asset classes are heading. We suspect that equities and other risk assets will be able to digest the first stage of rate tightening, albeit with heightened volatility around the time when the Fed starts preparing the market for another hike later this year. Unlike last September, earnings estimates are much more conservative. Bottom-up estimates foresee EPS rising by 3.9% in the U.S. and 5.4% in the rest of the world in 2019 (Chart 24). The combination of faster growth, easier financial conditions, and ongoing share buybacks implies some upside to these numbers. Perhaps more importantly, unlike in September, the Fed will only start hiking rates if the economy is performing well. Powell erred in saying that “rates were a long way from neutral” just when the U.S. economy was starting to slow. Had he uttered those words when U.S. growth was still accelerating, investors would have probably disregarded them. Jay Powell won’t make the same mistake again. Rather, he will make a different one: He will let the economy overheat to the point where the Fed finds itself clearly behind the curve and forced to scramble to catch up. The resulting stagflationary environment – where growth is slowing due to a shortage of available workers and inflation is on the upswing – will be toxic for equities and other risk assets. While it is difficult to be precise about timing, we recommend that investors maintain a modestly pro-risk stance over the next 12-to-18 months. However, they should pare back exposure to equities and spread product late next year before the Fed ramps up the pace of rate hikes. Prepare To Temporarily Upgrade International Stocks The U.S. stock market tends to be “low beta” compared to other bourses. If global growth accelerates in the second half of this year, international stocks will outperform their U.S. counterparts. We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and now recommend being outright long EM equities. We will be looking to upgrade both EM and European equities to overweight in the coming weeks in currency-unhedged terms once we see more confirmatory evidence of a global growth revival. We have mixed feeling about Japanese stocks. Stronger global growth will benefit Japanese multinationals, but firms focused on the domestic market may suffer if the government goes ahead and raises the sales tax in October. We would hold off upgrading Japanese stocks for the time being. At the global sector level, we pared back our defensive tilt earlier this year, after having turned more cautious last summer. We recommend that investors overweight energy and industrials. We are also warming up to financials and materials. The former will benefit from a steepening in yield curves later this year as well as from faster credit growth. The latter will gain from a more robust Chinese economy. We would maintain a neutral allocation to health care, info tech, and communication services. Real estate and utilities will both suffer once bond yields start moving higher. Classically defensive sectors such as consumer staples will also underperform.  Global Bond Yields Likely To Rise Global bond yields are likely to rise over the next 12-to-18 months as growth surprises on the upside. Yields will continue rising into the first half of 2021 as inflation accelerates. Unlike in past risk-off episodes, Treasurys will not provide much of a safe haven in the lead up to the next recession. As noted above, one of the reasons that bond yields are so low today is because the term premium is very depressed. The cumulative effect of Fed bond purchases has probably depressed the term premium, but the bigger impact has stemmed from the fact that investors see Treasurys as an insurance policy against various macro risks. Investors are accustomed to thinking that when an economy slides into recession, equity prices will fall, the housing market will deteriorate, wage gains will recede, job prospects will worsen, but at least the value of their bond portfolio will go up! The problem with this reasoning is that it is only valid when the Fed is hiking rates in response to stronger growth. If the Fed is hiking rates because inflation is getting out of hand, Treasury yields could end up rising while stocks are falling. This was actually the norm between the late-1960s and early-2000s (Chart 25). Chart 25Treasury Yields Could Rise While Stocks Fall Treasury Yields Could Rise While Stocks Fall Treasury Yields Could Rise While Stocks Fall If Treasurys lose their safe-haven status, the term premium will move higher. A vicious circle could develop where rising bond yields weaken the stock market, causing investors to flood out of both stocks and bonds and into cash, leading to even higher bond yields and lower equity prices. Investors should maintain a modest short duration stance towards Treasurys over the next 12 months, and then move to maximum underweight duration in mid-2020 as inflation starts to break out. Going long duration will only make sense once the Fed has raised interest rates into restrictive territory and the economy slides into recession. That is not likely to occur until the second half of 2021. Regionally, we favor European, Canadian, Australian, New Zealand, and especially Japanese government bonds over the next 12 months relative to U.S. Treasurys. The U.S. economy is at the greatest risk of overheating. In currency-hedged terms, the 10-year U.S. Treasury yield is among the lowest in the world (Table 1). Japanese 10-year bonds, for example, offer 2.72% in currency-hedged terms, while German bunds command 2.94%. Table 1Bond Markets Across The Developed World Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone   The U.S. Dollar: Heading Towards A Soft Patch Gauging the outlook for the U.S. dollar is a bit tricky. Even though the Fed will only be raising rates gradually over the next 12 months, it will still hike more than what is discounted by markets. With most other central banks still sitting on the sidelines, short-term rate differentials are likely to move in favor of the greenback. That said, aside from Japan, stronger global growth will likely prompt investors to price in a few more rate hikes in other developed economies in 2020 and beyond. Consequently, long-term yield differentials may not widen by as much as short-term differentials. Perhaps more importantly, the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 26). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world (Chart 27). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 26The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 27The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth If global growth picks up in the back half of this year, the dollar will likely peak in the second quarter and weaken over the remainder of 2019 and into 2020. The dollar’s trajectory may thus follow a similar course to the one in 2017, a year in which the Fed raised rates four times, but the broad trade-weighted dollar nevertheless managed to weaken by 7%. Chart 28The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency As was the case in 2017, the euro will probably gain ground later this year against the U.S. dollar as will most EM and commodity currencies. However, just as the Japanese yen failed to participate in the rally that most currencies experienced against the dollar in 2017, it will struggle to gain much traction against the greenback. The yen is a “risk-off” currency and thus tends to fall whenever global risk assets rally (Chart 28). In addition, the yen will suffer if global bond yields move up relative to JGB yields later this year, as will likely be the case if the BoJ is forced to prolong its yield curve control regime in the face of tighter fiscal policy. We would go long EUR/JPY on any break below 123. After First Weakening, The Dollar Will Rally Again Late Next Year As the U.S. economy encounters ever more supply-side constraints in 2020, growth will slow and inflation will accelerate. The Fed will respond by hiking rates more quickly than inflation is rising. The resulting increase in real interest rates will put upward pressure on the dollar. In this stagflationary environment, equities will tumble and credit spreads will widen. Tighter U.S. financial conditions will reverberate around the world, causing global growth to decelerate even more than it would have otherwise. This will further turbocharge the dollar. The greenback will only peak once the Fed starts cutting rates in late-2021. Commodities: Getting More Bullish A weaker dollar later this year, along with stronger global growth led by a resurgent China, will be bullish for commodities. BCA’s commodity strategists recommend going long copper at current prices. They are also maintaining their bullish bias towards oil. They expect Brent to average $75/bbl this year and $80/bbl in 2020. Higher U.S. shale output will be offset by delays in building out deepwater export facilities, which will keep supply fairly tight. In past reports, we discussed the merits of buying gold as an inflation hedge. However, we held back from doing so because of our bullish dollar view. Now that we see the dollar peaking over the next few months, we would be buyers of gold on any break below $1275/ounce.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 29 Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. Feature The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories promised would not mean losing access to the Common Market. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart 1). Chart 1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart 2), the erosion of its manufacturing economy (Chart 3), and the ballooning of the country’s financial sector (Chart 4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart 5). Chart 2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart 3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart 4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart 5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart 6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart 7). Chart 6 Chart 7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. The underlying economic angst has continued to influence British politics since Brexit. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart 8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart 9).3 Chart 8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart 9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. The idiosyncratic events that provided tailwinds behind Brexit … were the migrant crisis and terrorist attacks in Europe. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart 10). Neither forecast was popular with our client base, but both have been spot on. Chart 10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart 11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart 11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart 12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart 13). Chart 12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart 13...And Brits Feel More European ...And Brits Feel More European ...And Brits Feel More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. The British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart 14). Chart 14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram 1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Diagram 1Confused? You Are Not Alone The State Of Brexit The State Of Brexit Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart 15). Chart 15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. An election would induce volatility to the market as it would put Jeremy Corbyn close to the premiership. Furthermore, polling data (presented in Chart 12 and Chart 13) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart 12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart 16). Chart 16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The Conservative Party has wasted its window of opportunity to push a hard, or moderately hard, Brexit through Parliament. The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart 17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart 17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart 18). Chart 18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. It makes sense for long-term investors to buy the GBP … short-term investors should buy the 2-year call while selling 3-month ones. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart 19). Chart 19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President The Bank Credit Analyst mathieu@bcaresearch.com Footnotes 1 At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2 Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3 Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. ­4 One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5 Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7 President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line.

Highlights For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks. Tactically overweight Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM… …but prepare to take profits in the summer months. In the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps… …and EUR/USD has the scope to head higher. Feature Without a shadow of a doubt, the chart that causes the greatest stir among our clients is the Chart of the Week. It shows that one of the biggest investment decisions, the choice between the euro area and U.S. equity markets, reduces to the choice between the three large euro area banks – Santander, BNP Paribas, and ING – and the three U.S. tech behemoths – Apple, Microsoft, and Google.  Chart of the WeekEurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Clients are simultaneously amazed and unsettled by this manifestation of the Pareto Principle, which states that the vast majority of an effect is explained by a tiny minority of causes. Financials feature large in the Eurostoxx50 while tech giants dominate the S&P500. But the amazing thing is that almost all of the relative performance can be explained by just three stocks in each market. The vast majority of an effect is explained by a tiny minority of causes.  The chart creates a cognitive dissonance. What about the things that are supposed to matter for stock market selection: relative economic growth, profits growth, margins, valuations and geopolitics? The answer is that all of these are interesting areas of study, but they are mere details in the big picture. For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks (Chart I-2). Period.  Chart 2For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech Our view is that in the immediate future this is certainly possible, but that over the long haul it will prove to be a very tall order. When The Mean Is Meaningless The structural performances of vastly different equity sectors can diverge for a very long time. How long? Japanese banks have underperformed U.S. tech for thirty years and counting! In this situation, mean-reversion and ‘standard deviations’ from the mean become meaningless concepts (Chart I-3). Chart I-3Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! The statistical concept of a standard deviation is only meaningful if the underlying data is stationary, which is to say mean-reverting. If it isn’t, then it is impossible to say that a sector price or valuation is stretched either versus another sector, or versus its own history.  One problem is that sector performances and valuations undergo phase-shifts when they enter a different economic climate. The structural outlook for bank profits experiences a phase-shift when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is as meaningless as comparing your height as an adult to your height when you were a child! Sector performances and valuations undergo phase-shifts when they enter a different economic climate. To which, a frequent riposte is: within the same sector, euro area companies appear cheaper than their counterparts elsewhere in the world. But again, this apparent value is deceptive because it is simply an adjustment for the so-called ‘currency translation effect’ and the anticipated long-term moves in exchange rates. If investors anticipate the euro ultimately to strengthen – because they see that it is trading well below purchasing power parity – then a multinational company listed on a euro area bourse will suffer a future headwind to its mixed-currency denominated profits when they are translated back to a stronger euro. To discount this anticipated headwind, the euro area multinational must trade cheaper compared with a peer in, say, the U.S. But the cheapness is a false impression. Pulling together these complexities of sector effects, phase-shifts in sector valuations and currency effects, making the big call between Europe and America on the basis of performance or valuation mean-reversion is dangerous. Instead, we come back to the basic question: should you tilt towards euro area financials or towards U.S. tech? Own Banks For The Short Term Only Japanese financial sector profits peaked in 1990 and stand at less than half that level today. Euro area financial sector profits peaked in 2007, and are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan’s footsteps, expect no sustained growth through the next 17 years (Chart I-4). Chart I-4Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage – the amount of equity held against the balance sheet. More stringent European regulation is making this a headwind too. Banks have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin – the difference between rates received on loans and rates paid on deposits. In this regard, both fintech and the blockchain are likely to create a further headwind to bank profitability. Japan’s experience suggests that euro area financials will struggle to outperform structurally. Admittedly, U.S. tech may also face its own headwinds or phase-shift, most obviously antitrust lawsuits to counter its near-monopoly status. But even allowing for this, Japan’s experience suggests that euro area financials will struggle to outperform structurally. Rather, financials is a sector to play for outperformance phases lasting no more than a few quarters. Last autumn, we noted that short-term credit impulses in the major economies were flipping from a sharp down-oscillation into an up-oscillation phase (Chart I-5). On that basis, we recommended a tactical overweight to Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM. Those pro-cyclical sector positions have broadly succeeded, but they are still appropriate given that up-oscillation phases very reliably last around nine months. Chart I-5Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations The caveat is: prepare to take profits in the summer months. The Fed Is Now At ‘Neutral’, But Where Is The ECB? Last week, the Federal Reserve confirmed that “the Federal funds rate (at 2.5 percent) is now in the broad range of estimates of neutral – the rate that tends neither to stimulate nor to restrain the economy.”  This begs the question: where is the ECB policy rate (now at 0 percent) relative to its neutral? Our very high conviction view is that the ECB policy rate is well below neutral. Financials is a sector to play for outperformance phases lasting no more than a few quarters. The twenty year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Through these twenty years, the euro area versus U.S. long bond yield spread has averaged -50 bps1 (Chart I-6). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -50 bps (Chart I-7). Ergo, the real interest rate differential has averaged zero. Meaning, the ex-post neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-6The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... Chart I-7...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps With little difference in the neutral real rates over the past two decades, is there a valid reason to expect a difference in the future? An obvious response is the fragility of the euro area’s banking system will require the ECB to persist with its zero interest rate policy for years. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy. In fact, the evidence suggests that this fear is exaggerated. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy (Chart I-8). The problem has been localised in Italy, where bank lending relapsed once again in 2018. Chart I-8Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France However, on closer examination this was a direct result of political tensions. Recently, Italian bank lending has been a very tight (inverse) function of the Italian bond yield. The BTP yield spiked last year when Rome escalated its budget spat with Brussels, and bank lending took a hard hit. But now that the Italian bond yield has retraced, lending should recover (Chart I-9). Chart I-9Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down The central issue is can the U.S. policy rate – which is at neutral – and the ECB policy – which is below neutral – diverge much from here? Our high conviction answer is no. Therefore, in the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps, one way or the other (Chart I-10). Chart I-10Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? It also implies that after remaining range-bound in the immediate future, EUR/USD has the scope to head higher. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System This week’s recommended trade is to go long SEK/NOK, as it is close to the limit of tight liquidity that has signaled many previous technical reversals in this currency cross. Set a profit target of 1.5 percent with a symmetrical stop-loss. In other trades, the on-going rally in government bonds caused the short position in 30-year T-bonds to hit its stop-loss. This leaves us with five open positions. Long SEK/NOK. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long SEK/NOK Long SEK/NOK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart II-1). Chart II-1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart II-2), the erosion of its manufacturing economy (Chart II-3), and the ballooning of the country’s financial sector (Chart II-4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart II-5). Chart II-2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart II-3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart II-4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart II-5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart II-6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart II-7). Chart II-6 Chart II-7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart II-8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart II-9).3 Chart II-8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart II-9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart II-10). Neither forecast was popular with our client base, but both have been spot on. Chart II-10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart II-11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart II-11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart II-12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart II-13). Chart II-12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart II-13...And Brits Feeling More European ...And Brits Feeling More European ...And Brits Feeling More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart II-14). Chart II-14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram II-1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Chart II- Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart II-15). Chart II-15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. Furthermore, polling data (presented in Chart II-12 and Chart II-13 on page 28) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart II-12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart II-16). Chart II-16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart II-17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart II-17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart II-18). Chart II-18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart II-19). Chart II-19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic Senior Vice President Chief Geopolitical Strategist Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2       Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3       Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. 4       One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5       Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6       Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7       President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line.  

Highlights The odds of a continued earnings contraction have not yet fallen to the point that would warrant an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While we maintain Chinese stocks on upgrade watch and may recommend increasing exposure soon, the bottom line for investors is that it is still too early for us to confidently project a sustained uptrend. While most investors attribute the chronic discount of Chinese stocks relative to the global average as being due to a sizeable equity risk premium, our analysis suggests that China’s low payout ratio and mediocre earnings growth are the true causes. This implies that China’s re-rating potential is capped barring a major structural improvement in earnings growth. Investors should pay close attention to the details of a U.S./China currency stability pact that will reportedly be included in any trade deal between the two countries. Such a pact may set up an important natural experiment for CNY/USD, and could be a revelatory event for China’s exchange rate regime. Feature Last week’s FOMC meeting dominated the headlines of the financial press, and for good reason. The Fed surprised investors with a material downgrade to their expected path of the federal funds rate over the next three years, a shift that largely reflected concerns about global growth. The subsequent inversion of the U.S. 10-year / 3-month yield curve in response to the very disappointing euro area flash manufacturing PMI for March confirms that many investors remain convinced that Fed policy is too tight and that easing is likely over the coming year.1 On the positive side, investor concerns that reflationary policy is needed in the U.S. and euro area are likely overblown: the plunge in the euro area PMI at least in part reflects the near-term uncertainty over the possibility of a hard Brexit (which will probably be avoided), whereas the Fed is pausing at a level of real interest rates that is well below real GDP growth, which means that monetary policy is still stimulative for the U.S. economy (Chart 1). Chart 1U.S. Monetary Policy Is Still Stimulative U.S. Monetary Policy Is Still Stimulative U.S. Monetary Policy Is Still Stimulative But Chart 2 highlights that a generalized slowdown in global growth is responsible for at least part of the sharp weakness in Chinese export growth over the past few months, which we had been mostly attributing to a catch-up phase following a (perversely and ironically) beneficial tariff front-running effect that had temporarily boosted trade growth last year. Chart 2Global Weakness At Least Partly Responsible For A Sharp Export Slowdown Global Weakness At Least Partly Responsible For A Sharp Export Slowdown Global Weakness At Least Partly Responsible For A Sharp Export Slowdown Ongoing weakness in the global economy, were it to persist, would imply that China’s external demand outlook is even less encouraging than we had previously assumed. This would raise the stakes for a trade deal with the U.S. to be agreed upon soon, as well as a continued uptrend in the pace of Chinese credit growth. Investors should closely watch the new export orders component of the March NBS manufacturing PMI later this week for signs that exporter sentiment is improving, as well as the overall Caixin PMI to confirm that smaller firms continue to benefit from the PBOC’s targeted easing efforts. When Should Investors Upgrade Chinese Stocks On A Cyclical Basis? In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. In the wake of the near-vertical February rise in Chinese domestic stocks, the most common question we have received from clients is whether they should be increasing their cyclical exposure to Chinese stocks in general, and A-shares in particular. In response to the January surge in credit we placed Chinese stocks on upgrade watch in our February 27 Weekly Report,2 but we are not yet ready to recommend an outright cyclical overweight. Investors should be at the ready and aiming, but should not yet fire. In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. We have noted in several previous reports that investors have focused nearly exclusively on the U.S.-China trade war since the beginning of 2018, and have largely ignored a slowing domestic economy (Chart 3). Given this, it is not surprising that a sharp improvement in the odds of a deal (which occurred at the beginning of November) has led to a material rally over the past few months versus global stocks. Chart 3The Prospect Of A Trade Deal Has Been The Primary Driver Of China-Related Assets The Prospect Of A Trade Deal Has Been The Primary Driver Of China-Related Assets The Prospect Of A Trade Deal Has Been The Primary Driver Of China-Related Assets In fact, we predicted in our December 5 Weekly Report that positive sentiment about a deal would boost the relative performance of Chinese stocks over the coming few months, and recommended a tactical overweight stance at that time.3 A cyclical (i.e. 6-12 month) overweight, however, is a different story. Sentiment alone rarely drives financial markets over a 1-year time horizon, meaning that investors need to have some degree of confidence that domestic demand will meaningfully improve over the next 12 months to justify a cyclical upgrade. Certainly, we acknowledge that there have been several positive developments pointing to such an outcome. Chinese monetary conditions have become extremely easy, credit is no longer contracting and surged in January, the Caixin PMI rose notably in February, and some form of a trade deal remains the most likely outcome of the ongoing talks. In addition, Chinese stocks still remain significantly below their 2018 peak (Chart 4), meaning that there is still material potential upside if Chinese earnings do not contract. Chart 4Chinese Stocks Still Have Room To Rise If The Earnings Outlook Stabilizes Chinese Stocks Still Have Room To Rise If The Earnings Outlook Stabilizes Chinese Stocks Still Have Room To Rise If The Earnings Outlook Stabilizes A moderate credit expansion appears to be underway, but coincident activity continues to weaken and earnings appear to have more downside. However, there are also several reasons to be cautious cyclically: Chart 5The Past Three Months Imply A Moderate Credit Uptrend The Past Three Months Imply A Moderate Credit Uptrend The Past Three Months Imply A Moderate Credit Uptrend Chart 6Chinese Coincident Economic Activity Continues To Weaken Chinese Coincident Economic Activity Continues To Weaken Chinese Coincident Economic Activity Continues To Weaken Chinese and U.S. policymakers have not only failed to set a date for an agreement to be signed by President’s Xi and Trump, but recent new reports suggest that momentum may be slowing and that a meeting may be postponed until June or later.4 Even if the deal does not fall through, material further delays could cause investors to get anxious and vote with their feet. Such a selloff could be violent, given the extremely sharp rise in domestic stock prices over the past six weeks. The evidence so far points to a moderate expansion in credit (Chart 5), reflecting the fact that policymakers are still somewhat concerned about financial stability and the need to prevent significant further leveraging of the private sector. This means that the odds are not yet in favor of a credit “overshoot” like what occurred in 2015/2016, implying that the pickup in growth is likely to be comparatively weaker this time around. Since 2010, monetary conditions and money & credit growth appear to be the best predictors of investment-relevant Chinese economic activity.5 While a moderate credit expansion appears to be underway, there has been no discernable pickup in money growth.6 This discrepancy likely means that the recent improvement in credit has occurred due to non-bank financial institutions, further suggesting that this economic recovery will probably be less powerful and less broad-based than during past cycles. While a moderate expansion in credit does suggest that China’s economy will bottom at some point in the coming months, coincident economic activity continues to decelerate (Chart 6). A continuation of this trend, particularly if coupled with an investor “crisis of faith” in the trade talks, could lead to a very significant retracement in Chinese equity prices before durably bottoming for the year. Trailing EPS growth is decelerating, but it has yet to contract on a year-over-year basis as would be implied by the net earnings revisions ratio (Chart 7) and the coincident activity indicators shown in Chart 6. Chinese investable EPS fell 30% during the 2015/2016 episode (20% for domestic stocks), implying meaningful further downside even if economic activity does not weaken as significantly over the coming months. Chart 7Net Earnings Revisions Point To More Downside For Earnings Net Earnings Revisions Point To More Downside For Earnings Net Earnings Revisions Point To More Downside For Earnings Chart 8 presents a helpful way for investors to make a net assessment of all of the factors highlighted above. The chart shows our earnings recession model for the MSCI China Index, and shows what is likely to occur if a trade deal causes a full recovery in Chinese exporter sentiment, China’s export-weighted RMB stays roughly at current levels, and the very recent pace of credit growth (Dec-Feb) continues along its trend. Chart 8A Trade Deal And A Moderate Credit Expansion Will Likely Stabilize The Earnings Outlook A Trade Deal And A Moderate Credit Expansion Will Likely Stabilize The Earnings Outlook A Trade Deal And A Moderate Credit Expansion Will Likely Stabilize The Earnings Outlook This scenario, were it to occur, would reduce the odds of a continued earnings contraction to the point that we would be comfortable recommending an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While such a recommendation could come as soon as mid-April, the bottom line for investors is that it is still too early for us to confidently project this outcome. Should Chinese Stocks Be Priced At A Premium Or A Discount To Global Stocks? Most investors attribute the discount applied to Chinese stocks to a high equity risk premium (ERP), but our work paints a different picture. Besides questions about the appropriate cyclical allocation to Chinese stocks, the recent spike in interest among global investors towards A-shares has also led to a renewed focus about the degree to which Chinese stocks are cheap versus the global average. In a world where many financial assets are chronically expensive and Chinese policymakers appear to be responding to weaker economic activity, some investors question whether Chinese stocks deserve to be priced at a discount (Chart 9). Our sense is that most investors attribute the discount to a high equity risk premium (ERP) stemming from the enormous rise in Chinese non-financial corporate debt over the past decade, but our research paints a different picture. Chart 9The Chinese Equity Discount: A High ERP, Or Something More Sinister? The Chinese Equity Discount: A High ERP, Or Something More Sinister? The Chinese Equity Discount: A High ERP, Or Something More Sinister? One way of analyzing the risk premium of an equity market is to use the well-known constant Gordon growth model. Equation 1 below presents the theoretically justified 12-month trailing P/E ratio as a function of the payout ratio, the risk-free rate, the ERP, and the long-term dividend growth rate (which is equal to the long-term earnings growth rate given a constant payout ratio). Equations 2 and 3 re-arrange equation 1 to express the ERP and long-term growth rate, respectively, on the left-hand side of the equation. Equation 1: P0/E0 = (D1/E0)/(rf + ERP – g) Equation 2: ERP = [(D1/E0)/(P0/E0)] + g - rf Equation 3: g = rf + ERP-[(D1/E0)/(P0/E0)] To illustrate the approach, Chart 10 applies equation 2 to the U.S. equity market and compares it with the annual dividend discount model equity risk premium published by Professor Aswath Damodaran from New York University’s Stern School of Business,7 a well-known expert in the theory and practice of asset valuation. While there are some differences in the level of the series owing to slightly different methodologies, the overall profile of the two series is generally similar. Chart 10Our DDM Methodology For The U.S. Generates Results Similar To Other Important Estimates Our DDM Methodology For The U.S. Generates Results Similar To Other Important Estimates Our DDM Methodology For The U.S. Generates Results Similar To Other Important Estimates Proxying the market’s long-term growth expectations in a large, mature economy such as the U.S. is materially easier than is the case in an emerging market such as China. As such, instead of solving for the equity risk premium directly when judging whether China’s discount is “deserved”, we use equation 3 to solve for the implied long-term growth rate given an assumed (and very conservative) ERP range of 2-3%, using the global P/E ratio. In other words, we ask the following question: what kind of earnings growth do Chinese stocks need to achieve over the long run in order to justify the same earnings multiple as the global average, given an equity risk premium of 2-3%? Chart 11 presents the answer to this question, for both the domestic and the investable market. We use domestic 10-year bond yields as the risk-free rate in the case of the A-share market, and U.S. 10-year bond yields in the case of the MSCI China index as a proxy for the global risk-free rate. Finally, in each panel, the dashed horizontal lines denote the actual compound annual growth rate in earnings per share for each market, since the year noted next to each line. Chart 11A Low But Still Difficult L/T Earnings Hurdle Rate To Be Priced In Line With Global Stocks A Low But Still Difficult L/T Earnings Hurdle Rate To Be Priced In Line With Global Stocks A Low But Still Difficult L/T Earnings Hurdle Rate To Be Priced In Line With Global Stocks Two important points are apparent from the chart: The required growth rate for both markets to be priced in line with global stocks are quite low, well below Chinese nominal GDP growth. At first blush, this might suggest that the valuation discount applied to China reflects a sizeable equity risk premium that could shrink over the coming 6-12 months (i.e. a beneficial re-rating of Chinese stocks). Since 2010 or 2011, actual growth rates in EPS are materially above the required growth range in both markets. However, over more recent time horizons, particularly 2013 and later, actual earnings growth has not only been below the range but has also been extremely poor in absolute terms. This is particularly true for the investable market, which has actually recorded negative growth in 12-month trailing EPS since 2014 or 2015. A dividend discount model approach suggests that the Chinese equity market discount is justified, barring a major structural improvement in earnings growth. Chart 12 highlights the problem with China’s stock market in a nutshell. For both the investable and domestic equity markets, the dividend payout ratio is well below the global average. This is a normal circumstance for small companies with high growth potential; firms re-invest a high portion of their earnings back into the company in order to build out their asset base and deliver even higher earnings in the future. Chart 12The Chinese Discount Visualized: A Low Payout Ratio, And Mediocre Earnings Growth The Chinese Discount Visualized: A Low Payout Ratio, And Mediocre Earnings Growth The Chinese Discount Visualized: A Low Payout Ratio, And Mediocre Earnings Growth But panel 2 of Chart 12 shows that relative earnings for Chinese stocks versus the global average have not trended higher over the past decade, meaning that a higher earnings retention ratio among Chinese stocks has not led to a superior earnings profile. In response, global investors have rightly discounted Chinese stocks versus their global peers, a circumstance that is likely to continue unless Chinese earnings growth materially and sustainably improves. Our analysis implies that there is a natural limit to how far Chinese equities can ultimately be re-rated barring a major structural improvement in the economy, a factor that we may eventually have to contend with were we to recommend a cyclical overweight stance. Capped re-rating potential is unlikely to prevent Chinese stocks from trending higher in relative terms if economic fundamentals warrant an uptrend, but it may suggest that the duration or magnitude of the rise may be shorter than many investors hope. A Sino-U.S. Trade Deal: A Natural Currency Experiment In The Making? What explains the link between CNY-USD and the interest rate differential between the two countries? Finally, a brief note on the RMB. Since June 2018, changes in CNY-USD appear to have been closely aligned with the magnitude of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 13shows the levels implied by this framework in a variety of tariff scenarios, calculated based on the percent decline from the peak in the exchange rate in 1H 2018. As noted in our March 13 Weekly Report,8 CNY-USD today is consistent with the current tariff regime, implying potential upside if a trade deal with the U.S. rolls back some of the tariffs that have been imposed. Chart 13A Simple Equilibrium Framework Suggests CNY-USD May Rise Materially Further If Tariffs Are Rolled Back A Simple Equilibrium Framework Suggests CNY-USD May Rise Materially Further If Tariffs Are Rolled Back A Simple Equilibrium Framework Suggests CNY-USD May Rise Materially Further If Tariffs Are Rolled Back However, Chart 14 shows that CNY-USD has been closely correlated with the interest rate differential between the two countries for several years, with the relationship having recently become a leading one. Chart 14 highlights that CNY-USD has moved higher than the rate differential would imply (painting the opposite picture as that shown in Chart 13), suggesting that the currency is more likely to depreciate than appreciate over the coming 6-12 months barring tighter monetary policy in China or outright rate cuts in the U.S. Chart 14Will Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? Will Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? Will Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? The relationship shown in Chart 14 is surprising, and we have struggled to understand the exact dynamics at play. As we highlighted in a September report,9 many global investors take the relationship for granted, given the strong historical link between interest rate differentials and exchange rates in developed countries. However, a major problem that arises in explaining Chart 14 is the fact that uncovered interest rate arbitrage (or the “carry trade”) cannot easily occur or cannot occur at all when one or both countries involved maintains capital controls. It is an important conundrum, and one that we have not been able to solve. From our perspective, there are only two scenarios that explain the close relationship between the exchange rate and interest rate differentials between the two countries: The relationship is causal, implying that capital flows in and out of the country are sufficiently large to enable a carry trade. The two series are correlated because of a third factor related in some way to the other two. In our view, scenario 1 is not likely. Capital is flowing out of China, but at a much slower rate than before,10 and the relationship shown in Chart 14 did not break down following China’s capital crackdown in 2015/2016. Ruling out scenario 1 necessarily implies that scenario 2 is correct. Our best guess concerning the missing third factor is that Chinese policymakers are looking to the rate differential as a guide to set the exchange rate, in order to mimic a market-based exchange rate in support of China’s goals to progressively liberalize (and internationalize) the currency. If true, this implies that China has full control of their exchange rate regardless of the prevailing interest rate differential, but that they are often choosing to follow what the differential implies. This is significant, because if Chinese and U.S. negotiators do agree to a “yuan stability pact” as has been reported in the press, a trade deal may set up an important natural experiment for the currency. In our view, a major upward move in the rate differential is unlikely over the coming year, implying that CNY-USD will persistently deviate from the relationship shown in Chart 14 if President Trump is not inclined to tolerate any real weakness in the RMB over the coming year. While the details of the currency agreement and the trade agreement more generally could allow for some decline in CNY-USD if coupled with an offsetting benefit for the U.S. (such as materially higher U.S. exports to China for some period), our bias is to believe that President Trump does not want to see a stronger dollar over the coming year in the lead-up to the 2020 election. If true, investors should pay close attention to the behavior of CNY-USD, as it is stands to be a revelatory event for China’s exchange rate regime.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   1 Please see U.S. Bond Strategy and Global Fixed Income Strategy Weekly Reports “The New Battleground For Monetary Policy” and “Forward Guidance On Steroids”, dated March 26, 2019, for a detailed update on our view for Fed rate hikes and how investors should interpret the recent inversion in the yield curve. 2 Please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com 4 Please see “Some U.S. Officials Said To See China Walking Back Trade Pledges”, Bloomberg News, dated March 19, 2019, and “Donald Trump-Xi Jinping meeting to end US-China trade war may be pushed back to June, sources say”, South China Morning Post. 5 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “EM: A Sustainable Rally Or A False Start?”, dated March 7, 2019, available at ems.bcaresearch.com 7 Please see Professor Damodoran’s website for more information on his estimates of the equity risk premium. 8 Please see China Investment Strategy Weekly Report, “China Macro And Market Review”, dated March 13, 2019, available at cis.bcaresearch.com 9 Please see China Investment Strategy Weekly Report, “Moderate Releveraging And Currency Stability: An Impossible Dream?”, dated September 5, 2018, available at cis.bcaresearch.com 10 Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights The correlation between oil and petrocurrencies has deeply weakened in recent years. One of the reasons has been the prominence of new, important producers, notably the U.S. Oil prices should trend towards $75/bbl by year-end. This will favor the NOK, but the CAD and AUD will be held hostage to domestic slowdowns. Sell the CAD/NOK at current levels. Meanwhile, aggressive investors could begin accumulating USD/NOK shorts, given the Fed’s complete volte-face. Both the SNB and the BoE have delivered dovish messages, joining the chorus echoed by other central banks. However, the BoE remains a sideshow until the final chapter of the Brexit imbroglio unfolds. Feature Oil price dynamics have tended to have a profound impact on the trend of petrocurrencies. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payments dynamics also tend to improve during oil bull markets. Altogether, these forces combine to be powerful undercurrents for petrocurrencies. In the case of Canada and Norway, petroleum represents around 20% and 60% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher than in Norway. It is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Getting the price of oil right is usually the first step in any petrocurrency forecast. The Outlook For Oil1 Our baseline calls for Brent prices to touch $75/bbl by year-end. Oil demand tends to follow the ebbs and flows of the business cycle, with demand having slowed sharply in the fourth quarter of 2018 (Chart I-1). With over 60% of global petroleum consumed fueling the transportation sector, the slowdown in global trade brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. If, as we expect, the impact of easier global financial conditions begins to seep into the real economy, these trends should reverse in the second half of the year. BCA’s Commodity & Energy Strategy group estimates that this would translate into a 1.5% increase in oil demand this year. Chinese oil imports have already started accelerating, and should Indian consumption follow suit, this will put a floor under global demand growth (Chart I-2). Chart I-1Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Chart I-2Oil Demand Green Shoots Oil Demand Green Shoots Oil Demand Green Shoots This increase in oil demand will materialize at a time when OPEC spare capacity is only at 2%. In its most recent meeting, OPEC decided not to extend the window for production cuts beyond May, waiting to see whether the U.S. eases sanctions on either Venezuela, Iran or both. At first blush, this appeared bearish for oil prices. However, the bottom line is that global spare capacity cannot handle the loss of both Venezuelan and Iranian exports. Unplanned outages wiped off about 1.5% of supply in 2018. Lost output from both countries will nudge the oil market dangerously close to a negative supply shock (Chart I-3). Chart I-3 Bottom Line: If Venezuelan sanctions continue, we expect the U.S. will likely extend the current waivers to Iranian exports further out into the future. Meanwhile, demonstrated flexibility by OPEC makes it increasingly the fulcrum of the oil market. That said, the balance of risks for oil prices remain to the upside since a miscalculation by both sides is a possibility. The Good Old Days Historically, the above analysis would have been largely sufficient to buy most petrocurrencies, especially given the gaping wedge that has opened vis-à-vis the price of oil (Chart I-4). But the reality is that the landscape for oil production is rapidly shifting, with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members. Chart I-4Opportunity Or Regime Shift? Opportunity Or Regime Shift? Opportunity Or Regime Shift? In 2010, only about 6% of global crude output came from the U.S. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%, having largely been stable among constituents like Saudi Arabia, Iran and even Venezuela. Fast forward to today and the U.S. produces almost 15% of global crude, having grabbed market share from both developed and politically-fragile economies (Chart I-5). Chart I-5A New Oil Baron A New Oil Baron A New Oil Baron At the same time, the positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Put another way, rising oil prices benefit the U.S. industrial base much more than in the past, while the benefits for countries like Canada and Norway are slowly fading. U.S. shale output in the Big 5 basins rose by about 1.5 million barrels in 2018, close to the equivalent of total Libyan production. Meanwhile, Norwegian production has been falling for a few years.  The reality is that the landscape for oil production is rapidly shifting, with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time U.S. production was about to take off (Chart I-6). Since then, that correlation has fallen from around 0.8 to around 0.3. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the U.S. becomes a net energy exporter. Chart I-6Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble, and the Colombian and Mexican pesos. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Transportation bottlenecks for Canadian crude and falling production in Norway are also added negatives. The conclusion is that rising petrodollar reserves have historically been bullish for the currency (Chart I-7) but expect this correlation to be weaker than in the past.  Chart I-7Rising Petrodollar Reserves Will Be Bullish Rising Petrodollar Reserves Will Be Bullish Rising Petrodollar Reserves Will Be Bullish The Fed As A Catalyst The Federal Reserve recently completed the volte-face that it launched at its January FOMC meeting. The dots now forecast no rate hikes in 2019 and only one for 2020. Previously, three hikes were baked in over the forecast period. GDP growth has been downgraded slightly, and CPI forecasts have also been nudged down. Rising petrodollar reserves have historically been bullish for the currency but expect this correlation to be weaker than in the past. The reality is that U.S. growth momentum relative to the rest of the world started slowly rolling over at a time when external demand remained weak.2 Recent data confirm this trend persists: Industrial production peaked last year and continues to decelerate; the NAHB housing market index came in a nudge below expectations; and the U.S. economic surprise index is sitting close to its one-year low of -40. With bond yields having already made a downward adjustment by circa 100 basis points, the valve for financial conditions to get looser could easily be via the U.S. dollar (Chart I-8). We have been selectively playing USD shorts, mostly via the SEK and the euro, as per our March 8th report. Today, we add the Norwegian krone to the list. Chart I-8Bond Yields Down, Dollar Next? Bond Yields Down, Dollar Next? Bond Yields Down, Dollar Next? Sell CAD/NOK The Norges Bank hiked interest rates to 1% at yesterday’s meeting, which was widely expected, but the hawkish shift took the market by surprise. Governor Øystein Olsen signaled further rate increases later this year, at a time when global central banks are turning dovish. This lit a fire under the Norwegian krone. The 6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015.   The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation slightly above the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher (Chart I-9). Chart I-9The Norwegian Economy Is Faring Well The Norwegian Economy Is Faring Well The Norwegian Economy Is Faring Well Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-10). The 6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015, and our intermediate-term indicators suggest the next move is likely lower. Meanwhile, relative economic surprises are moving in favor of Norway, with export growth, retail sales and employment growth all outpacing Canadian data. The discount between Western Canadian Select crude oil and Brent has closed, but our contention is that the delay in Enbridge’s Line 3 replacement will likely push the discount back closer to $20/bbl. Chart I-10Sell USD Via CAD/NOK Sell USD Via CAD/NOK Sell USD Via CAD/NOK Over the longer term, both the Canadian and Norwegian housing markets are bubbly, but in the latter it has been concentrated in Oslo, with Bergen and Trondheim having had more muted increases. In Canada, the rise in house prices could rotate to smaller cities, as macro-prudential measures implemented in Toronto and Vancouver nudge investors away from those markets (Chart I-11).  Chart I-11Bubbly Housing In Norway And Canada Bubbly Housing In Norway And Canada Bubbly Housing In Norway And Canada The Canadian government has decided to provide residents with a potential line of credit in exchange for equity stakes of up to 10% in residential homes. The maximum home value that qualifies for this line of credit has been capped at C$480,000. While this does little to improve the affordability of houses in expensive cities, it almost guarantees that those in competitive markets will be bid up. This will encourage a continued buildup of household leverage. Historically, when the leverage ratio for Canada peaked vis-à-vis the U.S., it was a negative development for the Canadian dollar (Chart I-12).   Chart I-12The CAD Looks Vulnerable The CAD Looks Vulnerable The CAD Looks Vulnerable Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating short positions versus the U.S. dollar outright. Hold USD/SEK shorts established a fortnight ago, currently 3% in the money. Housekeeping We are taking profits on our short AUD/CAD position this week, with a 1.4% profit. As highlighted in our March 8th report, the Australian dollar has been severely knocked down, and is becoming more and more immune to bad news. Despite home prices falling by more than 5% year-on-year, worse than during the financial crises, the Aussie was actually up on the week. Meanwhile, Australian exports will be at the top of the list to benefit from China’s reflationary efforts.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, titled “OPEC 2.0: Oil’s Price Fulcrum,” dated March 21, 2019, available at ces.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Into A Transition Phase,” dated March 8, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data in the U.S. have shown more signs of a slowdown: February industrial production growth missed expectations, coming in at 0.1% month-on-month. Michigan consumer sentiment in March came in higher than expected at 97.8. NAHB housing market index in March came in at 62, below consensus. January factory orders slowed to 0.1% month-on-month.  Philadelphia Fed business outlook came in at 13.7, surprising to the upside. Initial jobless claims in March were 221k, also outperforming analysts’ forecast. The DXY index slumped by 0.8% post-FOMC, and is now slowly recovering on the strong data from the Philly Fed business outlook and initial jobless claims. The Fed left interest rates unchanged on Wednesday, while further signaling that no rate hike is likely through 2019. Moreover, 2019 GDP forecast was downgraded to 2%. The dovish turn by the Fed could weigh on the dollar in the coming weeks. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in the euro zone have been mostly positive: February consumer price index came in line at 1.5% year-on-year; core consumer price index also stayed at 1% year-on-year. The seasonally-adjusted trade balance in January improved to 17 billion euros. Q4 labor cost fell to 2.3%. ZEW economic sentiment survey came in at -2.5 in March, outperforming the consensus of -18.7. EUR/USD increased by 0.5% this week. The FOMC-led sharp rebound sent EUR/USD to a new week-high of 1.145 on Wednesday. We expect more positive data coming from the euro zone, which will further lift the euro. 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 continued to soften: The merchandise trade balance came in at 339 billion yen in February. Total imports contracted by 6.7% year-on-year, while total exports fell by 1.2% year-on-year. Industrial production increased by 0.3% year-on-year in January. Capacity utilization in January fell by 4.7% month-on-month, missing expectations. The leading economic index in January fell to 95.9 from a previous reading of 97.2. USD/JPY slumped by 0.9% this week. Last Friday, the Bank of Japan left its key interest rate unchanged at -0.1%, as wildly expected. The 10-year government bond yield target also stayed unchanged at around 0%. Like many global central banks, the BoJ has been blindsided by the deep external slowdown that is beginning to seep into the domestic economy. 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 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: Average earnings excluding bonuses in January grew in line by 3.4%. ILO unemployment rate in January fell to 3.9%. The retail price index in February stayed in line at 2.5% year-on-year. The February consumer price index increased to 1.9% year-on-year. Retail sales growth in February increased to 4% year-on-year, outperforming expectations.  GBP/USD fell by 1.1% this week, erasing the gains triggered by dollar weakness earlier on Wednesday. The BoE left its interest rate unchanged at 0.75%, and the sterling continues to show more volatility with a delayed Brexit. 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 shown the housing market is toppling over: The housing price index in Q4 fell sharply by 5.1% year-on-year. New jobs created in February were 4,600, missing the expectations by 9,400. Moreover, 7,300 full-time employment jobs were lost, while 11,900 positions were created for part-time employment. The unemployment rate in February fell to 4.9%, while the participation rate decreased to 65.6%. AUD/USD appreciated by 0.6% this week. It pulled back a little after reaching a 0.7168 high on Wednesday following the dovish Fed decision. During a speech this week, RBA highlighted the concerns over the ability of households to service their debt. Both external and internal constraints remain headwinds for the Australian dollar. 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 weak: Credit card spending growth in February slowed to 6.4% year-on-year. Q4 GDP growth came in at 2.3% year-on-year, underperforming consensus of 2.5%. The current account deficit widened to 3.7% of GDP in Q4. NZD/USD appreciated by 0.5% this week. The Q4 GDP breakdown showed that growth was mainly driven by the rise in service industries. Primary industries, however, fell by 0.8%. Agriculture was down 1.3%, mining was down 1.7%, forestry and logging fell 1.6%, and lastly, the fishing activity was down 0.9% quarter-on-quarter. The Kiwi will benefit from any dollar weakness, but is not our preferred currency. 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 continue to paint a mixed picture: January manufacturing shipments increased to 1% month-on-month. Foreign portfolio investment in Canadian securities saw an increase of C$49 billion in January, while Canadian portfolio investment in foreign securities decreased by C$8.4 billion. January wholesale sales growth increased to 0.6% month on month. USD/CAD rebounded overnight after falling sharply on a dovish Fed. CAD finally ended the week flat. On Tuesday, Bill Morneau, the Finance Minister of Canada, unveiled the new federal budget for 2019. It showed several new measures aiming to assist young and senior Canadian citizens, including first-time home buyers. While these measures might appease Canadian millennial voters, they will also result in significant deficits. The deficit projection for the year 2019-2020 widened to $19.8 billion, which could crowd out private spending. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The trade balance in February came above expectations at 3,125 million CHF. Exports came in at 19,815 million CHF, while imports came in at 16,689 million CHF, respectively. USD/CHF depreciated by 1% this week. The Swiss National Bank left the benchmark sight deposit rate unchanged at -0.75%, as wildly expected. We struggle to see any upside potential for the franc, amid a dovish central bank, an expensive currency and muted inflation. 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 has been positive. The trade balance in February fell to 15.8 billion NOK, from a previous reading of 28.8 billion NOK. USD/NOK fell by 1.3% this week. The Norges Bank raised rates by 25 bps to 1%, in line with expectations, while signaling further rate hikes in the second half of this year. The Norges Bank once again demonstrated to be the most hawkish among G10 members. The bank reiterated that the economy is running at a solid pace and capacity utilization is above normal levels, while inflation keeps navigating above the bank’s target. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There has been no major data release from Sweden this week. USD/SEK fell by 1.5% this week. Our short USD/SEK position is now 3% in the money since we initiated it 2 weeks ago. As we see more signs of recovery in the euro zone, we expect the exports of Sweden to pick up, which is a tailwind for the Swedish krona. 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

Dear Client, I had the pleasure of visiting clients in Seattle, Anchorage, and Juneau last week. In this week’s report, I address some of the questions that routinely came up during our meetings. Among other things, the topics discussed include our optimistic global growth outlook, waning dollar bullishness, implications of a more dovish Fed on the business cycle, and where we think equities are headed. Next week we will be publishing our Quarterly Strategy Outlook, which will provide a detailed discussion of our key global macro and investment views. Best regards, Peter Berezin, Chief Global Strategist Feature Q: You have predicted that global growth will stabilize in the second quarter and then accelerate in the second half of the year. Are you seeing much evidence in support of this view? A: We are seeing signs of green shoots, but they are still fairly tentative. Current activity indicators appear to have stabilized (Chart 1). The global manufacturing PMI edged lower in February, but the services component increased. Consumer confidence has risen, although that may simply reflect the rebound in global equities. Chart 1Global Growth Appears To Have Stabilized Global Growth Appears To Have Stabilized Global Growth Appears To Have Stabilized The data on international trade has been quite soft. That said, the weekly Harpex shipping index, which measures global container shipping activity, has improved. The Baltic Dry Index has also shown some signs of bottoming (Chart 2). Chart 2Shipping Data Pointing To A Recent Pickup In Global Trade Shipping Data Pointing To A Recent Pickup In Global Trade Shipping Data Pointing To A Recent Pickup In Global Trade The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has also moved higher (Chart 3). It generally leads the global LEI. The fact that global financial conditions have eased significantly since the start of the year is also an encouraging sign. Chart 3The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up Q: What’s your take on the most recent Chinese economic data? A: It has been generally soft, but not abysmal. Manufacturing output continues to decelerate. Retail sales remain lackluster, with auto sales showing little evidence of improvement. Property prices are still rising, but floor space sold has begun to contract. Fixed-asset investment has held up so far this year. However, this is mainly due to a pickup in spending among state-owned companies. Both exports and imports contracted in February. In a rather unusual step, the government announced last week that exports increased by nearly 40% in the first nine days of March compared with the same period last year.1 Electricity production has also apparently rebounded. We would not place a huge weight on these statements, as the data probably has been skewed by the timing of the lunar new year, but it does seem that economic momentum may be starting to turn the corner. We are seeing signs of green shoots, but they are still fairly tentative. There is little doubt that the government is trying to jumpstart growth. Household and business taxes have been cut. The PBOC has reduced reserve requirements by 350 bps over the past year. Interbank rates have dropped. Despite the fact that the February credit data fell short of expectations, the six-month credit impulse has turned decisively higher. The Chinese credit impulse leads imports by about six-to-nine months (Chart 4). This bodes well for global trade in the second half of the year. Chart 4Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Q: Given that Chinese debt levels are already quite high, by how much more can they realistically increase? A: We do not expect credit growth to rise by as much as it did in 2009 or 2016. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 5).2 As long as the government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. Chart 5China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth In any case, given that debt now stands at 240% of GDP, a mere one percentage-point increase in credit growth would still produce a hefty 2.4% of GDP in credit stimulus. In this sense, China may be better off with a higher debt-to-GDP ratio since in steady state this will allow for a larger flow of credit-financed stimulus into the economy. Q: A revival in Chinese growth would presumably help Europe? A: Yes. Our conversations with clients revealed an ongoing negative bias towards Europe among investors (Chart 6). This is echoed in the latest BofA Merrill Lynch Global Fund Manager Survey which, for the first time in history, identified “short European equities” as the most crowded trade. Chart 6European Equities: Unloved And Unwanted European Equities: Unloved And Unwanted European Equities: Unloved And Unwanted We think that such deep pessimism about Europe is largely unwarranted. Faster global growth will help the European export sector later this year, while domestic demand will benefit from more accommodative fiscal policy and lower bond yields, especially in Italy. The ECB will not raise rates this year even if growth speeds up, but the market will probably price in a few more rate hikes in 2020 and beyond. This will allow for a modest re-steepening in the yield curves in core European bond markets, which should be positive for long-suffering bank profits. Political risk remains a concern. The Brexit saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 7), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 7U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Q: You seem less bullish on the U.S. dollar than you were last year? A: That is correct. As we discussed last week, the dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth (Chart 8). If global growth strengthens later this year, the trade-weighted dollar will probably weaken. Chart 8The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Moreover, as this week’s FOMC meeting highlighted, the Fed’s reaction function has shifted in a more dovish direction. The median Fed dot now foresees no rate hikes this year and only one rate hike in 2020. In contrast, the December Summary of Economic Projections envisioned two rate hikes this year and one next year. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth. In a far cry from his October “rates are far from neutral” comment, Jay Powell stressed during this week's post-FOMC meeting press conference that the fed funds rate is currently in the “broad range of estimates of neutral.” While we would not rule out the possibility that the FOMC will raise rates at some point later this year, we now expect a more gradual pace of rate tightening than we had earlier envisioned. Q: Does a more dovish Fed imply that the economic expansion has even further to run? A: Yes. Expansions tend to end when monetary policy turns restrictive. We had previously thought that this point could be reached in late-2020, but it is now starting to look as though it will occur later than that. Broadly speaking, we see the Fed tightening cycle unfolding in two stages. In the first stage, which is the one we are in today, the Fed will raise rates in baby steps in response to better-than-expected growth and falling unemployment. In the second stage, the Fed will hike rates more aggressively as inflation starts to accelerate. Risk assets will be able to digest the first stage, but not the second. The good news is that most of our favorite indicators are not yet pointing to a major inflationary upswing (Chart 9): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s propriety Inflation Pipeline Indicator has fallen to a two-and-a-half-year low. Chart 9No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... Wage growth has accelerated, but productivity growth has increased by even more. Unit labor cost inflation has actually been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 10). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 10... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being Beyond then, the risks are high that inflation will move up as the economy continues to overheat. This could force the Fed to start raising rates aggressively late next year, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in 2021. Q: So stay overweight stocks for now, but consider selling at some point next year? A: Correct. The MSCI All-Country World Index (ACWI) has risen by over 14% since we upgraded it in December after having moved to the sidelines six months earlier. Given this run-up, we are not as bullish now as we were at the start of the year. Most of our favorite indicators are not yet pointing to a major inflationary upswing. Nevertheless, the path of least resistance for equities remains to the upside. While the forward P/E ratio for the MSCI ACWI has returned to where it was last September, analyst earnings expectations are currently much more conservative: Bottom-up estimates foresee EPS rising by 4.1% in the U.S. and 5.3% in the rest of the world in 2019 (Chart 11). The combination of faster growth, easier financial conditions, and ongoing corporate buybacks implies some upside to those estimates. Chart 11Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Moreover, real yields have fallen over the past five months – the 10-year U.S. TIPS yield is 48 basis points below its Q4 average, for example. A simple dividend discount model would suggest that global equities are about 10%-to-15% cheaper than they were prior to last year’s autumn selloff. The path of least resistance for equities remains to the upside. Q: Aren’t you worried that rising labor costs will push down profit margins even if GDP growth accelerates? A: Not really. As noted above, productivity growth has picked up. Whether this is the start of a new trend remains to be seen, but at least for now, it is dampening unit labor costs. Historically, real unit labor costs – nominal unit labor costs divided by the corporate price deflator – have tracked economy-wide profit margins very closely (Chart 12). Chart 12Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely In practice, it is very rare for earnings to contract outside of recessions (Chart 13). This is why recessions and equity bear markets generally overlap (Chart 14). With the next recession still two years away, it is too early to turn defensive. Indeed, as Table 1 shows, the second-to-last year of business-cycle expansions is often the most lucrative for stock market investors. Chart 13Earnings Rarely Contract Outside Of Recessions Earnings Rarely Contract Outside Of Recessions Earnings Rarely Contract Outside Of Recessions Chart 14Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Table 1Too Soon To Get Out Questions From The Road Questions From The Road Q: What do you recommend in terms of regional equity allocation? A: If global growth accelerates later this year and the dollar weakens, this will create an excellent environment for international stocks – EM and Europe in particular. Investors should prepare to overweight those regions at the expense of the United States (currency unhedged). Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Elaine Chan, “China spreading ‘positive news’ of strong export rebound in early March after February plunge,” South China Morning Post, March 11, 2019. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 15 Tactical Trades Strategic Recommendations Closed Trades

Highlights This report presents our framework for estimating Chinese capital outflows on a monthly basis, which investors can use as a real-time indicator to monitor the risk of another serious episode of capital flight. We also provide a monthly estimate of illicit capital outflow, which we find is negatively correlated with “on balance sheet” capital flows. This implies that Chinese residents alternate their use of the two channels in their attempt to move money out of the country. Our monitoring framework suggests that outflow pressure is more likely to ease than intensify if a trade deal is struck over the coming few weeks or months, especially given the rise in CNY-USD since early-November. However, we have identified a low-odds but high-impact scenario in which a shaky trade deal with the U.S. generates an unstable equilibrium that could ultimately escalate into a major Chinese capital outflow event. This could prove to be a highly destabilizing event for investors, and thus bears close monitoring. Feature Fears of a new round of capital outflow from China re-emerged in the second half of 2018 as USD-CNY approached 7, a psychologically important level for many investors (Chart 1). The last episode of significant capital outflows from China occurred in late-2015 following the PBOC’s devaluation of the RMB, and the sharp spike in volatility that resulted had a contagious effect for global financial markets. Chart 1A Near Miss Late Last Year A Near Miss Late Last Year A Near Miss Late Last Year In the very near term, the risk of a similar event appears to be low given the material trade talk-driven decline in USD-CNY that has occurred over the past five months. However, several news reports over the past year concerning the possible risk of another episode of capital flight underscore that China’s cross-border capital flow statistics are misunderstood by financial market participants. This raises the risk that investors either fail to anticipate a capital outflow event in the future or exaggerate the odds of one occurring. In this report we present our framework for estimating Chinese capital outflows on a monthly basis, which investors can use as a real-time indicator to monitor the risk of another serious episode of capital flight. We also adjust the typical measure of short-term capital flow derived from the quarterly balance of payments to account for cross-border RMB settlement, and present an estimate of illicit capital outflow that suggests Chinese residents alternate their use of legal and illegal channels in their attempt to move money out of the country. We then combine these three direct measures of capital flow with two indicators of expected RMB depreciation to further augment our monitoring efforts. We conclude by noting that while outflow pressure is more likely to ease than intensify if a trade deal is struck over the coming few weeks or months, we have identified a low-odds but high-impact scenario in which a shaky trade deal with the U.S. generates an unstable equilibrium that could ultimately escalate into a major Chinese capital outflow event. This scenario is not part of our base case outlook, but could prove to be a highly destabilizing event for investors and thus bears close monitoring. Defining Short-Term Capital Flow From The Balance Of Payments Table 1 presents China’s balance of payments (BOP) for the four quarters ending in Q3 2018, with all items shown on a net basis. The table is organized in a way that provides a helpful refresher on the formulation of the balance of payments, namely that the current account (“CA”, made up of the trade balance and primary & secondary income) plus the sum of the capital account (“KA”), the financial account (“FA”), and a balancing item (referred to as net errors & omissions, “NEO”) is equal to 0, when capital and financial outflows are recorded with a minus sign. Current account surpluses necessarily involve net financial outflows (i.e., investment); whereas current account deficits must be funded by financial inflows (i.e., borrowing). Table 1 highlights that what financial market participants typically refer to as “capital” flows are actually recorded in the financial account of the balance of payments. While derivatives are included in the table for the sake of completion, in practice they are usually quite small (as is the case for the actual “capital” account). Table 1China’s Balance Of Payments Monitoring Chinese Capital Outflows Monitoring Chinese Capital Outflows The bottom panel of Table 1 indicates that the balance of payments formula can be rearranged so that it represents how many market participants tend to define total and short-term capital outflows from a balance of payments perspective. As we will show in the next section of the report, this re-arrangement of the balance of payments formula is an essential element in building a more frequent proxy of short-term capital flow. We define short-term capital flow from the balance of payments as the combination of portfolio investment, other investment, and net errors & omissions. The bottom panel shows that by adding reserve assets (“RA”) to the current account (“CA”), the right hand side of the BOP equation becomes the sum of direct investment (“DI”), portfolio investment (“PI”), other investment “OI”, and net errors & omissions (“NEO”). Since direct investment tends not to be driven by short-term economic behavior and is normally not influenced by foreign exchange expectations or fluctuations, the formula can be further arranged to isolate short-term capital outflows on the right-hand side: Current Account + Changes in Reserve Assets + Direct Investment ≈ (Portfolio Investment + Other Investment + Net Errors & Omissions)*-1 Or using our line item notation, CA + RA + DI ≈ -PI - OI - NEO The formula above is expressed as an approximation rather than an identity simply because it excludes the capital account (“KA”) and financial derivatives (“FD”). As can be seen in Table 1, the net value of adding the four quarter rolling total of CA + RA + DI to PI + OI + NEO is US$ 3.3 billion; adding KA + FD (-0.35 and -2.95 billion US$, respectively) would result in a value of 0. Chart 2 shows this relationship visually; and highlights that both series are nearly identical. Chart 2Short-Term Capital Flow As Defined By The BOP Short-Term Capital Flow As Defined By The BOP Short-Term Capital Flow As Defined By The BOP Building A Better Proxy Of Short-Term Capital Flow The balance of payments approach is a useful starting point for measuring short-term capital flow, but it has two important drawbacks: Timeliness: Balance of payments data are reported in quarterly frequency, and often with a lag. This is inadequate for most investors, particularly when market participants are concerned that a crisis or crisis-like conditions may be emerging. This is the primary disadvantage of the BOP approach. Failure to account for cross-border RMB settlement: The balance of payments approach implicitly assumes that a current account surplus in China will automatically result in the importation of foreign exchange, but this assumption is no longer fully valid. Cross-border RMB settlement now accounts for part of China’s foreign trade settlement, reaching more than 30% during the 2015/2016 period. Compared with its peak level, RMB settlement as a share of total foreign trade has fallen over the past two years, but still accounts for 19% today (Chart 3). To more precisely gauge China’s capital outflows, cross-border RMB settlement should be removed from the current account surplus, because trade payments settled in RMB would not involve the receipt of foreign currency. This offsetting current account discrepancy would still show up in the balance of payments under net errors & omissions, but that would have the effect of distorting our definition of short-term capital flow. Chart 3Analysts Need To Adjust The Current Account For Cross-Border RMB Settlement Analysts Need To Adjust The Current Account For Cross-Border RMB Settlement Analysts Need To Adjust The Current Account For Cross-Border RMB Settlement Chart 4 illustrates the difference between our quarterly definition of short-term capital flow and the series adjusted for cross-border RMB settlement. The chart shows that the two series are quite similar for most of the past decade, with the notable exception of the 2015/2016 period. The adjusted series suggests that the intensity of China’s episode of capital flight did not peak in 2015, but rather late in 2016. This is consistent with domestic commentary at the time,1 and implies that the PBOC faced headwinds in their attempt to stem capital outflows that were even worse than has been generally acknowledged. Chart 4After Adjusting For Cross-Border Settlement, Outflow Intensity Only Peaked In Late-2016 After Adjusting For Cross-Border Settlement, Outflow Intensity Only Peaked In Late-2016 After Adjusting For Cross-Border Settlement, Outflow Intensity Only Peaked In Late-2016 Unfortunately for investors, dealing with the lack of timeliness in the release of China’s balance of payments statistics is a more challenging endeavor. This problem cannot be resolved with simple adjustments to the quarterly data, and instead requires the building of a proxy for short-term capital flow based on the BOP equation but using monthly statistics. Investors can proxy our adjusted quarterly balance of payments-based measure of short-term capital flow on a monthly basis. As we referenced above, the key to constructing a monthly capital flow estimate lies with the re-arrangement of the balance of payments equation such that short-term capital flow is expressed as being approximately equal to the sum of the current account, direct investment, and the change in reserve assets (when outflows of the latter two series are recorded as negative values). Table 2 highlights that high quality monthly series are available to act as proxies for these three balance of payments components, after accounting for cross-border RMB settlement and the following two additional adjustments: Table 2Components Of BCA’s Monthly China Capital Outflow Indicator Monitoring Chinese Capital Outflows Monitoring Chinese Capital Outflows Services Balance: The trade balance accounts for the vast majority of the current account of most countries, and this is also true in the case of China. An underappreciated fact about China’s trade balance is that it has shrunk considerably over the past several years, due to what is now a sizeable services deficit. Some market commentators who are aware of the services deficit point to it as evidence that China’s net importation of services is laying the groundwork for its “new economy” (via eventual import substitution), but the reality is that travel (i.e. net tourism spending) accounts for over 80% of it (Chart 5). For the purposes of our monthly capital flow proxy, a sizeable services deficit is a complication that must be accounted for, given that China’s monthly trade statistics (and most monthly trade data globally) represent the trade in goods, not the trade in services. Since most of the fluctuations in the trade balance occur due to net trade in goods, we include the history of the quarterly services balance in our monthly indicator as a structural variable, and extend the most recent quarterly value into the current quarter as a simplifying assumption. Currency Valuation Effect on Official Reserves: Foreign exchange reserves in the balance of payments are calculated by the historical cost method, whereas the highly followed monthly official foreign exchange reserve data released by the PBOC is measured using market value. Changes in its balance, in addition to genuine changes in foreign exchange reserve assets, also reflect revaluation effects caused by fluctuations in the foreign exchange market. To dampen these effects, we include foreign exchange reserves in our monthly capital flow proxy in SDR terms rather than in U.S. dollars, rebased to the value of the underlying U.S. dollar series as of December 2018. Chart 5Travel (i.e. Tourism) Accounts For The Majority Of China's Services Deficit Travel (i.e. Tourism) Accounts For The Majority Of China's Services Deficit Travel (i.e. Tourism) Accounts For The Majority Of China's Services Deficit Chart 6 presents our quarterly balance of payments-based capital flow measure (adjusted for cross-border capital flow) with our monthly proxy, based on the series shown in Table 2 and the adjustments noted above. Divergences between the series exist in level terms, but panel 2 shows that our monthly proxy does a good job capturing the trend in the quarterly series. The only major exception to this occurred at the beginning of 2016, when our monthly proxy fell sharply relative to the adjusted quarterly BOP version. Chart 6Our Monthly Proxy Captures The Trend In Quarterly Capital Flows Our Monthly Proxy Captures The Trend In Quarterly Capital Flows Our Monthly Proxy Captures The Trend In Quarterly Capital Flows This sharp decline is a bit of a mystery; it can be traced to the official reserves series, and either suggests that capital outflow was materially worse in Q4 2015 and Q1 2016 than officially recognized, or that China suffered outsized losses from the risky asset portion of its reserve portfolio during that period. However, the first explanation is at odds with the evidence noted earlier that the intensity of capital flight seems to have peaked in late-2016, and the second explanation is inconsistent with the history of financial market returns over the past decade. We noted in a February 2018 Special Report that risky U.S. assets (almost entirely stocks) accounted for as much as 9.5% of China’s foreign reserve assets in the summer of 2015,2 and it is true that U.S. equity returns were quite negative from December 2015 to February 2016. But this was certainly not the first and only period of extreme U.S. equity market volatility to occur since 2010, raising the question of why this sharp decline in official reserves only occurred in 2015/2016. Future research on the topic of Chinese capital flows will aim to reconcile the difference between our monthly proxy and our adjusted quarterly balance of payments series during this period, but for now we are confident that the former contributes meaningfully to our understanding of the latter, particularly on a rate of change basis. Import Over-Invoicing: A Third Measure Of Short-Term Capital Outflow Investors need to track both legal and illicit capital flows. Our first two measures of short-term capital flow were based on an attempt to track the legally allowable movement of funds out of China. However, illicit capital outflow is an acknowledged problem in China, which tends to occur through the practice of import over-invoicing.3 Chart 7 presents our estimate of import over-invoicing for China, based on a methodology articulated by Global Financial Integrity, a U.S. non-profit organization that provides analysis of illicit financial flows globally (see Appendix A). The chart highlights two important points: Chart 7Illicit Capital Outflows: Another Way That Money Leaves China Illicit Capital Outflows: Another Way That Money Leaves China Illicit Capital Outflows: Another Way That Money Leaves China Illicit outflows have increased significantly over the past 2 years following China’s capital control crackdown, particularly in Q3 2018 following the announcement of the second round of U.S. import tariffs against China. Panel 2 of Chart 7 illustrates that there is a negative correlation between “on balance sheet” capital flows and illicit capital outflows, implying that Chinese residents alternate their use of the two channels in their attempt to move money out of the country. This underscores the importance of monitoring both channels on an ongoing basis. Investment Conclusions Table 3 brings together the three measures of short-term capital flow that we have laid out above, as well as two indicators of expected RMB depreciation (Chart 8): net settlement of foreign exchange by Chinese banks (see Appendix B), and the 3-month moving average of the percent deviation of CNH-USD (offshore RMB) from CNY-USD (onshore RMB). Altogether, the series shown in Table 3 form the basis of our capital outflow monitoring efforts, and we plan on updating these series regularly to gauge whether outflow pressure is increasing. Table 3Dashboard For Monitoring Short-Term Capital Flows Monitoring Chinese Capital Outflows Monitoring Chinese Capital Outflows Chart 8Two Indicators Capturing Expectations Of Severe RMB Depreciation Two Indicators Capturing Expectations Of Severe RMB Depreciation Two Indicators Capturing Expectations Of Severe RMB Depreciation For now, only our measure of illicit capital outflow is flashing a warning sign, and the timing of the recent spike in the measure appears to be closely connected with the trade war with the U.S. This implies that outflow pressure is more likely to ease if a trade deal is struck over the coming few weeks, as we expect will occur. However, we noted in a March 6 joint Special Report with our Geopolitical Strategy service that a deal with only slight concessions from China may stand on shaky ground and that tariff rollbacks will be limited or non-existent.4 This would ensure elevated policy uncertainty in the aftermath of the agreement and would raise the probability of a relapse into another trade war ahead of the 2020 U.S. election. In this scenario we would be watching the indicators shown in Table 3 closely for signs that increasing pessimism about the long-term state of sino-U.S. relations is causing the capital outflow “dam” built by policymakers following the 2015/2016 episode to buckle. Our monitoring framework suggests that the odds of a major capital flight event are currently low. But a shaky trade deal with the U.S. could change that. It is not part of our base case outlook, but onshore concerns of a renewed trade war with the U.S. next year could theoretically become self-fulfilling, if another major episode of capital flight were to weaken the RMB in a way that could even remotely be construed as a violation of the yuan stability pact that will reportedly be part of any agreement between the U.S. and China. While this would in no way entail a purposeful devaluation by Chinese policymakers to boost trade competitiveness, it could nonetheless provide an excellent excuse for President Trump to reinstate damaging economic pressure on China in the midst of what is likely to be a highly competitive re-election campaign. This could, in turn, produce a feedback effect that magnifies the original desire to move capital out of China, and would likely prove to be a highly destabilizing event for global financial markets. Stay tuned!   Qingyun Xu, CFA, Senior Analyst qingyunx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Appendix A Measuring Import Over-Invoicing In this report we use one of the two methodologies employed by Global Financial Integrity to measure import over-invoicing in China, which compares a country’s reported trade statistics with that of its global trade partners.5 Using the IMF’s Direction of Trade Statistics data, we deflate Chinese import data measured on a C.I.F. (cost insurance and freight) basis to an F.O.B. (free on board) basis using an assumed freight and insurance factor of 10%. Then, we use Hong Kong re-export data to adjust global exports to China for re-exported trade through Hong Kong. The formula is listed below: Chinese Import Over-invoicing = [(Chinese Imports From The World)/1.1] - Adjusted Global Exports To China   Appendix B The Onshore Market For Foreign Exchange A poorly understood fact about China’s capital/financial account regime is that a material amount of foreign exchange reserves are now held by enterprises and individuals. Most investors are familiar with China’s old foreign exchange settlement policy (established formally in 1993), which prohibited enterprises from retaining foreign currency. Exporters receiving foreign currency as payment for goods and services had to sell all foreign exchange receipts to designed banks, and purchase foreign exchange from these banks when needed to make payments to offshore suppliers. Thus, while this policy was in effect, the PBOC held all China’s foreign exchange reserves and official reserves equaled total reserves. However, since the early-2000s, this policy has been gradually withdrawn. Since its complete abolishment in 2012, foreign exchange retained by enterprises and residents has increased materially. Chart B1 shows the impact of these changes on the bank foreign exchange settlement and sale rates. The settlement rate represents enterprises’ sale of foreign exchange to banks as a share of their total foreign exchange receipts in a given month, while the sale rate represents banks’ sale of foreign exchange to enterprises as a share of enterprises’ total foreign exchange payments. The chart shows that the settlement rate has dramatically dropped since 2012 (from 70% to less than 50%). We can also see there were spikes in the settlement rate and sale rate in August 2015 (in contrary directions) when the PBOC devalued the RMB, implying that the demand for forex and presumably the expectation of further RMB depreciation was severe. Chart B1The Evolution Of China’s Domestic Foreign Exchange Market The Evolution Of China's Domestic Foreign Exchange Market The Evolution Of China's Domestic Foreign Exchange Market ​​​​​​​   Given this, we view net FX settlement (enterprises’ sale of foreign exchange to banks minus banks’ sale of foreign exchange to enterprises) as a reasonable proxy of expected RMB depreciation, and have included it as part of our capital flow monitoring framework.         1 “China’s capital outflow is still intensifying”, Reuters China Finance and Economics Column, December 19, 2016. 2 Please see China Investment Strategy Special Report, “Demystifying China’s Foreign Assets”, dated February 28, 2018, available at cis.bcaresearch.com. 3 Import over-invoicing occurs when an importer (in country A) attempts to evade capital controls by colluding with an exporting entity (in country B) to falsify the reported value of goods imported into country A from country B. The importer “overpays” for the goods in question and, usually through an intermediary, moves the surplus funds into the importer’s offshore account. Please see https://www.gfintegrity.org/issue/trade-misinvoicing/ for more information about the mechanics of and motivations behind trade misinvoicing. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, “China-U.S. Trade: A Structural Deal?”, dated March 6, 2019, available at cis.bcaresearch.com. 5 “Illicit Financial Flows to and from 148 Developing Countries: 2006-2015”, Global Financial Integrity, January 2019. Cyclical Investment Stance Equity Sector Recommendations