Economy
Highlights Wage inflation in the EU28 is running at exactly the same rate as in the U.S. In the euro area, it is only modestly lower. As the current business cycle completes, the euro area versus U.S. bond yield spread will narrow, one way or the other. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Feature Largely unnoticed and without great fanfare, Europe has just overtaken the U.S. on a very important labour market measure. For the first time in living memory, the percentage of the working age (15-64) population that is in the labour force is higher in Europe than it is in the U.S., for both men and women (Chart of the Week). Chart of the WeekMale Labour Force Participation Is Now Higher In Europe Than In The U.S. One putative explanation is that as U.S. baby boomers have aged, people older than 64 have chosen to remain in the labour force, which has indirectly weighed on the U.S. 15-64 participation rate. But the phenomenon of baby boomers staying in the workforce is common to both Europe and the U.S. and cannot explain the extent of outperformance in European labour participation - a ten percentage point catch-up since the start of this millennium (Chart I-2). Chart I-2Labour Force Participation Is Now Higher ##br##In Europe Than In The U.S. The true explanation is that the European female participation rate has been in a major structural uptrend (Chart I-3) while the U.S. male participation rate has been in a major structural downtrend (Chart I-4). Chart I-3European Female Labour Force Participation##br## Is In A Structural Uptrend Chart I-4U.S. Male Labour Force Participation##br## Is In A Structural Downtrend Misleading Comparison 1: The Unemployment Rate In Europe Vs The U.S. This week, our purpose is not to discuss the reasons behind these labour participation trends - as we covered these in our recent report How Women Are Powering The European Economy.1 Rather, we want to point out one important repercussion: when the participation rate is changing, the unemployment rate is a misleading measure of labour market slack. When labour participation is rising, a seemingly high unemployment rate overstates true slack; conversely, when labour participation is falling, a seemingly low unemployment rate understates true slack. To understand why, consider a population in which the numbers employed, unemployed, and officially inactive stand at 95:5:25. The unemployment rate is 5%. But let's assume that ten officially inactive people could, with some mild encouragement, participate in the formal labour market. This means the true slack is fifteen people, or 14%.2 Now imagine that five of the officially inactive people join the formal labour force, albeit with a slightly higher unemployment rate given their inexperience in the formal labour force. Under these circumstances, the numbers employed, unemployed, and officially inactive might reasonably change to 99:6:20. The unemployment rate has increased to 5.7%, suggesting slack has increased. But the truth is that slack has actually decreased to eleven people, or 10%.3 Clearly, the process also works the other way. If somebody leaves the formal labour force, it might depress the unemployment rate, giving the impression of a tight labour market. But the impression would be misleading. As a recent paper from the Federal Reserve Bank of Boston pointed out:4 "Informal work arrangements, such as gig economy jobs... embodies an economically significant amount of labour market slack that is not captured in the U-3 unemployment rate and other standard estimates of slack... Informal work can be viewed as slack because most informal work participants would drop informal work for formal work, (thereby) adding potential labour supply to the formal market that could reduce pressure on measured wages" Is there any direct evidence for this thesis? Yes, the evidence is compelling. Standard measures of slack, such as the unemployment rate, suggest that the labour market has substantially more slack in Europe than in the U.S. (Chart I-5). Yet wage inflation is running at exactly the same rate in the EU28 as in the U.S. (Chart I-6). And in the euro area, it is only modestly lower (Chart I-7). Chart I-5The Unemployment Rate Suggests Much More ##br##Slack In Europe Than In The U.S. ... Chart I-6...But Wage Inflation ##br##Is Identical! Chart I-7Euro Area Wage Inflation##br## Is Not Far Behind This brings us to a glaring structural anomaly which must eventually correct. The gulf in monetary policy between the ECB and the Fed - reflected in the bond yield spread - has become unsustainably stretched relative to the economic fundamentals, specifically the difference in wage inflation which in reality is very modest (Chart I-8). As the current business cycle completes, we expect this bond yield spread to narrow, one way or the other. Chart I-8The U.S.-Euro Area Bond Yield Spread Is Stretched ##br##Relative To The Wage Inflation Differential Misleading Comparison 2: Equity Valuations In Europe Vs The U.S. Staying on the theme of Europe versus U.S. comparisons which are highly misleading, let's share one of the most common questions we get: are European equities relatively cheap, as their headline valuation suggests? The answer is an emphatic no. Compared with currencies and bonds, mainstream stock markets have little connection with the economies of their countries or regions of domicile. Mainstream stock markets are just collections of multinational companies, with each stock market defined by its own unique sector fingerprint. Sectors with vastly different structural growth prospects - say, financials and technology - must necessarily trade on vastly different valuations. So the sector with the lower headline valuation is not necessarily the cheaper sector. By extension, the stock market with the lower headline valuation because of its sector fingerprint is not necessarily the cheaper stock market. This means that a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is highly misleading. To which, a frequent follow-up question is: within the same sector, are European companies cheaper than their counterparts elsewhere in the world? The answer is, not necessarily. To understand why, consider the international cruise company Carnival which has a dual listing, one in London, one in New York. The London listing has recently traded at a substantial discount to the New York listing (Chart I-9 and Chart I-10). Does this mean that the London listing is cheap? Of course not. If it were, the markets would arbitrage away this valuation anomaly instantaneously! Chart I-9Carnival Can Trade On A Different Valuation##br## In London And New York... Chart I-10...Because Of The Currency##br## Translation Effect On the face of it, the valuations of Carnival's two listings should be the same because the underlying company is the same. However, the London and New York valuations can deviate substantially because of the so-called 'currency translation effect'. An international company like Carnival will intentionally receive its sales and profits across multiple global currencies - say, dollars and pounds, but a stock market listing is denominated in just one currency. If investors anticipate the dollar ultimately to weaken versus the pound - because they see that the pound is structurally cheap today - they might downgrade Carnival's multi-currency profit growth expectations in pound terms. Thereby, the London listing will trade at a discount to the New York listing. But the discount is a false impression. Allowing for the anticipated decline in the dollar versus the pound, the London listing is not cheap. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. European Equity Relative Performance Has Little Connection With European Economic Relative Performance Given the large distortions to stock market valuations from sector effects and currency translation effects, picking markets on the basis of relative valuation is a very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express. This creates a paradox. The overall economic fundamentals in Europe, correctly measured, are not inferior to those in the United States. Yet European stock market relative performance has very little to do with Europe's relative economic performance. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Unfortunately, this will necessarily weigh on their long-term relative performance prospects. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform other major markets. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Given its overweighting to healthcare - Novartis and Roche - and healthcare's outperformance this year, the SMI should have fared well in the first half. However, this tailwind was countered by a stronger headwind - the SMI has a huge underweight to oil and gas, which is the one cyclical sector that has outperformed. But as we pointed out last week, the performance of oil and gas equities is technically stretched, and will require strong momentum in the crude price to extend further. Therefore, we like the combination of overweight healthcare, underweight oil and gas - which is precisely what Switzerland's SMI offers (Chart I-11). Chart I-11Switzerland = Long Healthcare, Short Energy Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report, 'How Women Are Powering The European Economy' dated June 7, 2018 available at eis.bcaresearch.com 2 5/(95+5) = 5%, (5+10)/(95+5+10) = 14% 3 6/(99+6) =5.7%, (6+5)/(99+6+5) = 10% 4 The Federal Reserve Bank of Boston Current Policy Perspectives No. 18-2 'Wage Inflation and Informal Work' by Anat Bracha and Mary A. Burke, October 2017. Fractal Trading Model This week we note that the outperformance of consumer services versus consumer goods is technically stretched. The 65-day fractal dimension is at a limit that has reliably signalled reversals. The recommended trade is short global consumer services versus consumer goods. Set a profit target of 2.5% with a symmetrical stop-loss. 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-12 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
NOTE: There will be a few minor scheduling changes to BCA's China Investment Strategy service in July. We will publishing next week's report and the report scheduled on July 25 one day late, on Thursday, July 5 and 26, respectively. There will also be no report on Wednesday, July 18 due to our regular summer break. Highlights In response to the sharp spike in the risk of a full-blown U.S./China trade war, many market participants have concluded that significant fiscal and/or monetary policy stimulus is forthcoming. But for now, a depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it also increases the risk that the U.S. will follow through with the worst of their threats. Despite two conceivable upside scenarios for the equity market, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan trade for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Feature Chart 1A Decisive Technical Breakdown In ##br##Ex-Tech Stocks Vs Global In a Special Alert last week, we recommended that investors downgrade Chinese ex-tech stocks versus their global peers to neutral from overweight,1 after having placed them on downgrade watch at the end of March.2 Our recommendation was made in response to the ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices.3 It was also timely, as Chinese ex-tech stock prices have now decisively broken below their 200-day moving average (Chart 1). Following our shift in stance, the question facing BCA's China team, as well as global investors, is straightforward: Now what? Stimulus Watch The answer to this question among many market participants is that fiscal and/or monetary policy stimulus is forthcoming. We have no doubt that China will announce some remedial or compensatory measures in response to protectionist action from the U.S. Indeed, recent statements from the Ministry of Finance (MOF) suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. However, we have argued that the bar for a fresh round of material stimulus is higher today than it was in the past, and we continue to hold this view. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy likely needs to feel more pain before policymakers come to its aid with enough magnitude to potentially spark another upswing in economic activity. Below we outline a few perspectives on the potential for stimulus, and how investors can gauge whether policymakers are deploying enough stimulus to materially impact China's economic outlook: Fiscal Stimulus The MOF's statement reflects the first fiscal policy action that China would likely take to combat any economic weakness, which is to speed up spending that has already been approved but was planned to occur later in the year. But from the perspective of whether a policy action is likely to materially boost economic activity, frontloading pre-approved spending would qualify, at best, as a remedial measure. In our view, tracking China's budgetary government finance data represents the best method for investors to determine whether policymakers are truly stimulating via the fiscal channel. While it is true that China's shadow budget deficit is much larger than the official data show (Chart 2), there is a crucial aspect of China's recent mini-cycle that is not well understood by many investors: almost all of the expansion of China's fiscal stance from 2014-16 was from on-budget rather than off-budget spending. Given that China has been trying to limit off-budget spending as part of its structural reform program, our sense is that this time won't be different if China decides that significant fiscal stimulus is required. This is good news for investors, given that on-budget spending is easier to observe in real-time, and Chart 3 presents two simple measures that we are using to monitor China's fiscal stance, alongside their year-over-year changes: on-budget expenditure and the on-budget balance, both as a % of GDP. Based on these measures there are no signs yet that the fiscal stance is easing (in fact, the opposite has occurred over the past year), but we will watching Chart 3 closely over the coming months for any indication of a change. Chart 2China's Shadow Budget Deficit Is Large... Chart 3...But If China Stimulates It Will Likely Be On-Budget Monetary Stimulus In our judgement, the recent cut to the reserve requirement ratio is not likely to be effective at stimulating the domestic economy. Investors should note that the initial reaction of many market participants to the April 17 reserve requirement ratio cut of 1% was that it represented a shift in the PBOC's policy stance towards easing, which ultimately proved to be a false narrative. Chart 4 shows China's 3-month interbank repo rate (China's de-facto policy rate which leads average lending rates), and highlights the timing of two specific events: March 28, when news broke that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, and April 17, when the PBOC announced its targeted reserve requirement ratio cut. The chart makes it clear that the decline in the repo rate was in response to the deadline extension rather than the repo rate cut. This is entirely consistent with the findings of our February 22 Special Report,4 particularly the fact that 75% of the monetary tightening that has occurred since late-2016 has been regulatory in nature. We have previously argued that the dip in the repo rate in response to the deadline extension would probably be temporary,5 and Chart 4 shows that the rate has indeed increased over that past two months. In short, there is no evidence that the April 17 reserve ratio cut had any measurable effect on the stance of monetary policy in China. Given this, there are two key points for investors. The first is that small cuts to the reserve requirement ratio should be viewed, at best, as remedial measures that may help blunt the impact of shock to the export sector, but they are unlikely to alter the downward trajectory of the "old economy" (the portion of China's economy that is most relevant to global investors). The second is that if cuts to the reserve requirement ratio or any other monetary policy action stimulates the provision of credit via easier lending standards (rather than by reducing the cost of borrowing), their effect should result in a pickup in broad measures of credit growth rather than a reduction in interest rates. Chart 5 highlights that, for now, no such pickup has occurred; adjusted total social financing, which excludes equity issuance but includes municipal bonds, remains in a downtrend. This series, along with its impulse equivalent, are both included in the BCA Li Keqiang Leading Indicator which is at the core of our efforts to monitor the cyclical condition of China's business cycle. Chart 4No Evidence That April RRR Cut Eased Interest Rates Chart 5No Evidence That April RRR Cut Eased Lending Standards The Exchange Rate BCA's Geopolitical Strategy team has recently argued that China is likely to retaliate to a potential tariff imposition by weakening CNY/USD. This would have the effect of improving the competitiveness of exports priced in RMB, or would bolster the revenue of exporters selling goods priced in U.S. dollars (by way of receiving more RMB after converting the dollars received). Evidence has emerged over the past week to suggest that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar. Chart 6 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have, until very recently, reflected the strength in the U.S. dollar. However, the chart shows that CNY/USD has fallen over the past few days by magnitude in excess of what would be expected given movements in the U.S. dollar, implying that the very recent weakness is likely policy-driven. Chart 6The PBOC Is Letting CNY/USD Depreciate We agree that depreciating the currency versus the U.S. dollar will improve the financial condition of domestic exporters, but we would also caution investors against looking at a deep depreciation in CNY/USD in an encouraging light. We have noted in previous reports that such a development would be a clear sign of an outright, full-scale trade war between the U.S. and China, and in this context currency deprecation should still be classified as just a remedial measure (i.e. it is unlikely to lead to a renewed upswing in Chinese economic activity). Bottom Line: A depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it may also invite even further protectionist action from the U.S. Investment Recommendations Our recommendation to cut Chinese ex-tech stocks to neutral means that investors should be looking both for upside and downside risks when judging when to make their next allocation shift. For now, our discussion above underscores that we view the risks largely to the downside. The scenario that would cause us to further downgrade Chinese stocks to underweight within a global equity portfolio is not difficult to imagine: the worst outcome in the U.S. / China trade dispute materializes, the global economy slows meaningfully, and the inertia from the ongoing structural reform program causes Chinese policymakers to limit their stimulus to compensatory, remedial measures until a painful slowdown emerges in the domestic economy. We are not yet past the "point of no return" on the way to this outcome, but the events of the past two weeks have clearly moved us further along the path. Conversely, there are two scenarios that we can envision that could cause us to upgrade Chinese stocks back to overweight: Chart 7Keep Monitoring Floor Space Sold A protectionist exchange occurs between China and the U.S. but fails to devolve to the most damaging outcome. China's remedial measures are successful at easing the pain from tariffs on domestic producers, and the economic outlook stabilizes. In this scenario the most acute risk would be removed, but the gradual underlying downtrend in China's "old economy" would be intact. In this case we would be more comfortable upgrading Chinese stocks if there was an additional reflationary tailwind, such as a boost from fiscal spending or some reversal of the monetary tightening that has occurred since late-2016. But a significant, exogenous acceleration in economic activity from some other sector of China's economy would also fit the bill, and we have argued in past reports that housing appears to be the best candidate. Chart 7 highlights that residential sales volume may now be in a gradual uptrend, which could translate into stronger construction in the months ahead. The second scenario that would cause us to upgrade Chinese stocks is straightforward: Chinese policymakers determine that the risks to growth from an export shock are unacceptably large given the existing slowdown in the industrial sector, and decide to temporarily reverse course on the structural reform path by opting for "big bang" fiscal and/or monetary stimulus. A significant and highly investment-relevant mini-cycle upswing occurred in China the last time that the authorities strongly prioritized growth, and we will watching closely for real indications of a shift in attitude in this direction. For now our judgement is that policymakers have a higher pain threshold than in the past, suggesting that this is outcome is not yet probable. Related to our decision to downgrade Chinese ex-tech stocks to neutral within a global equity portfolio, we have three updates to our trade book: We are closing our long MSCI China / short MSCI Taiwan position and upgrading our Taiwanese cyclical stance to neutral: Despite being massively overweight technology stocks, Chart 8 highlights that Taiwan is a comparatively low-beta equity market versus China. Our trade has generated a 21% return since we initiated it in February 2017, and we believe it is time to book profits. Given Taiwan's small size it is actually possible that its economy and/or equity market will suffer disproportionately if the worst U.S. / China trade outcome materializes, which could cause us to revisit the trade. But for now our judgement is that a neutral position is warranted. We are sticking with our long China onshore corporate bond trade: We would certainly expect credit spreads on Chinese corporate bonds to flare in response to a deteriorating economic outlook, but we highlighted in our June 13 Weekly Report how high the bar is for investors to lose money on these bonds.6 In short, China's corporate bond market already offers a margin of safety given its high yield and a comparatively short duration, and we do not see recent developments on the trade front as a sufficiently compelling reason to exit the trade. We are initiating a new trade - within the MSCI China index, long low-beta sectors / short benchmark: Chart 9 presents the relative US$ stock price return of a portfolio of low-beta level 1 GICS sectors within the MSCI China index, relative to the index itself. Our methodology in calculating the portfolio is the same as that employed in the A-share factor analysis that we presented in our June 13 report; namely it is a value-weighted portfolio of sectors with below-median rolling 1-year market beta.7 The chart shows that the portfolio has outperformed over time, but sold off quite substantially last year as the high-flying tech sector boosted the performance of the overall index. The relative performance trend for low-beta has recently strengthened and crossed above its 200-day moving average, which we regard as a supportive technical signal to initiate the trade. Chart 8Taiwan's Equity Market Is Low Beta Vs China's Chart 9Go Long Low-Beta Sectors Vs The Broad Market Bottom Line: Despite two potential upside scenarios, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com. 3 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 6 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. 7 The current sector weights of the portfolio are: 26% telecom services, 24% industrials, 19% health care, 16% utilities, and 14% consumer staples. Cyclical Investment Stance Equity Sector Recommendations
Highlights We have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range; when the economy is at full employment, stocks are more likely to sell off after these sideways periods than if there is still some slack in the labor market. Feature The outlook for global risk assets will likely be more challenging in the coming months. With that in mind, we have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. BCA still expects that the U.S. stock-to-bond ratio will grind higher in the next 12 months, as U.S. stocks move sideways and Treasury yields climb (Chart 1A and 1B). We recommend that investors put the proceeds from the sale of equity positions into cash. Chart 1AScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.80% Chart 1BScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.29% Within a fixed-income only portfolio, we are selling credit and putting the proceeds into Treasuries. We maintain our underweight duration stance given our view of the Fed and the 10-year Treasury. At 2.91%, the 10-year is still below BCA's view of fair value (3.29%). Moreover, BCA's position is that the Fed's gradual path of rate hikes is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels.1 On the credit side, we note that late in the cycle the yield curve is moderately flat, between 0 and 50 bps. Work by our U.S. Bond Strategy team2 shows that periods when the curve is flat are consistent with much lower excess returns than when the slope is above 50 bps (Chart 2). Given the low potential reward, a neutral posture on credit makes the most sense. Investors will not give up too much by starting to downgrade early. Tomorrow's U.S. Bond Strategy report will provide more details on the corporates versus Treasuries allocation. Chart 2Corporate Bond Performance And The Yield Curve BCA has recommended overweight positions in U.S. risk assets since spring 2009 when equities became attractive from a risk/reward perspective. At that time, the U.S. economy was weak, the Fed was easing, equity valuations were depressed and forward earnings estimates were dismal (Chart 3). In contrast, the risk/reward for risk assets today is much less attractive. The economy is in the late stages of an expansion and is running beyond full employment. The central bank is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (Chart 3 again). This means that good news is already priced into the equity market. When the Shiller PE, a measure of the market's valuation, is between 30 and 40, 1-year returns are tepid at best (Chart 4). Chart 3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Chart 4Expected Returns Given Starting Point Shiller P/E We are not trimming exposure to risk assets because we are more concerned about the economic outlook. BCA's view is that odds of a U.S. recession in the next 12 months remain low. Furthermore, the traditional recession signals that we track do not suggest a recession is nigh (Chart 5). For example, the 2/10 yield curve is still positive at 34 basis points (panel 2). Upward movement in long-dated breakevens will offset some of the upward pressure at the front-end from further Fed rate hikes, limiting the amount of curve flattening during the next few months. Once long-dated breakevens get back to a range between 2.3% and 2.5% then flattening could proceed more rapidly.3 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The May LEI rose by 6% year-over-year. Initial claims for unemployment insurance in the week ending June 16 were 24K below their mid-December 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. The bottom line is that we are not concerned about a recession. Nonetheless, BCA's Equity Scorecard has dropped to 2, below the critical value of three that has been consistent in the past with positive equity returns (not shown). Table 1 updates our Exit Checklist of items that are important for the equity allocation call. Three of the nine are now giving a 'sell' signal and they suggest that prudence is necessary, despite the constructive economic outlook. Chart 5No Recession Signal Here Table 1Exit Checklist For Risk Assets Furthermore, several technical indicators that we monitor signal caution. The National Association of Active Investment Managers (NAAIM) says that active managers have increased equity risk since the start of the year (Chart 6). At 89%, the average equity exposure of institutional investors is close to the cycle high reached in March 2017, which was the highest since 2007, just before the S&P 500 peak in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated. At slightly under 2, it is at a position where bear markets began in 2000 and 2007, and it is well above the level seen just before the 2015 bear market (Chart 7, panel 1). That said, not all technical indicators are flashing red. Chart 8 shows that BCA's Technical Indicator is not at an extreme (panel 1). Moreover, BCA's Equity Sentiment Composite Index is neutral (panel 2); panel 3 shows that the U.S. large cap equities remain in the middle of their 2009-2018 recovery channel, albeit in the top half of the channel. Note that the S&P 500 tested the top end of the channel (near 2850) in January 2018. Chart 6Active Managers Have Increased ##br##Equity Exposure This Year Chart 7Equity Speculation Is Elevated Chart 8Not All Technical Indicators Are Bearish The risk to our neutral stance on equities is that credit and equities will rally to fresh highs before the cycle is done. However, given our bias for capital preservation and views on the late stage of the business cycle, it is not advisable to reach for the last few drops of return. With equity valuations stretched, we would rather be early and judicious and miss out on the last few basis points of outperformance rather than be late and underperform as risk assets sell off. BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 when it finds itself behind the curve on inflation. Moreover, because inflation is at the Fed's 2% target and the economy is beyond full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that the Fed will be reluctant to deviate from its tightening path even in the face of more turmoil in the EM space or in Europe. This supports our guarded view on equities and our decision to move into cash instead of Treasuries. Geopolitical risk is another reason to be cautious. Chart 9 shows that globalization, a tailwind for risk assets, is stalling. Moreover, there is an increased threat of a breakup in the Eurozone, led by political uncertainty in Italy (Chart 10). In addition, tensions with Iran are mounting. Nonetheless, our Geopolitical Strategy service notes that the U.S.'s relationship with China is the primary source of geopolitical peril (Chart 11).4 Although we are not adjusting our view on the dollar,5 a stronger greenback would bolster our case for caution on risk assets. A higher dollar would hurt the profits of U.S. multinationals and could lead to instability in the emerging markets, raising the odds of a policy misstep. Chart 9Globalization Has Reached Its Zenith Chart 10Risk Of Eurozone Breakup Is Rising Chart 11BCA's Geopolitical Power Index Illustrates A Multipolar World Equity volatility will accelerate through year end, as is often the case late in equity bull markets. Bottom Line: If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months, especially if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Treading Water BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range (See Appendix Charts 1 and 2).6 We excluded bear markets and recessions from our analysis because our view is that neither condition will occur in the next 12 months. Table 2 shows that these sideways episodes lasted an average of eight months. At the end of six of the ten intervals, U.S. large cap equities rallied (1986, 1988, 1992, 1997-1998, 2004, and 2015); after two phases, stocks recovered briefly and then sold off (1951-52 and 1972). At the conclusion of the 1991 episode, stocks rallied and then resumed moving sideways. Stocks sold off after the eight-month sideways phase in 1976. Table 2What Happens After Stocks Move Sideways? Four (1951-52, 1972, 1988, 1997-98) of the ten sideways periods occurred after the U.S. economy reached full employment. The 10 year Treasury yield increased as stocks moved sideways in 1972 and in 1988, but fell in the 1997-98 episode. The S&P 500 PE ratio increased in two sideways phases (1972 and 1997-98) and contracted in 1988. S&P 500 EPS growth accelerated in 1972, 1988 and 1997-98 phases. The S&P 500 rallied after the sideways episodes in 1988 and 1997-98, but sold off after the 1951-52 and 1972 sideways phases that occurred after the economy hit full employment (Chart 12). Chart 12S&P 500 Valuations, EPS Growth, Margins And The 10-Year Treasury Yield When Stocks Move Sideways As the S&P 500 moved sideways when the economy was not yet at full employment (1976, 1986, 1991, 1992, 2004 and 2015), 10-year Treasury yields fell four times (1976, 1986, 1991 and 1992) and rose in two (2004 and 2015). The forward PE ratio for the S&P 500 expanded in 1986 and 1992, but contracted in 1991, 2004 and 2015. EPS growth during sideways episodes for stocks when the economy was not yet at full employment is mixed. EPS growth accelerated in 1976, 1992 and 2004, but slowed in 1986, 1991 and 2015 as oil prices fell. U.S. large cap equities rallied after four of the sideways periods when the economy was not yet at full employment (1986, 1992, 2004 and 2015) but sold off after the 1976 sideways move (Chart 12 again). We intend to further examine the macro backdrop during sideways periods for U.S. equities in future Weekly Reports. Bottom Line: BCA expects bond yields to rise in the next 12 months and S&P 500 profit growth will peak. Stocks are more likely to move higher after a period of sideways price action if the economy is not at full employment. Rising PE ratios as stocks move sideways most often lead to equity rallies after the sideways phases end. With valuations already elevated, PEs are unlikely to expand much further in this cycle. Moreover, the U.S. economy reached full employment in early 2017, making it less likely that the Fed will hit the pause button on its rate hike regime. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA's U.S. Bond Strategy Weekly Report, "As Good as It Gets For Corporate Debt," published April 24, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," published June 19, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA's Geopolitical Strategy "Are You Sick of Winning Yet," published June 20, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," published June 20, 2018. Available at gis.bcaresearch.com. 6 There are well-established periods for bull and bear markets for U.S. equities, however not for "sideways" episodes for stocks. We have defined "sideways" as a period of range-bound equity price movements that have lasted for at least five months outside of recessions and bear markets. Readers may have other definitions of "sideways". APPENDIX CHARTS Chart 1Sideways Epsisodes For Stocks 1950-1980... Chart 2..And 1980-2018
While copper prices remain comfortably within the $2.90 to $3.30/lb range they've occupied this year, the rising threat of a Sino - U.S. trade war spilling into the global trading system, along with slowing credit and monetary stimulus in China, will continue to roil copper markets. Refined copper prices - like most commodities - are highly sensitive to the level of world copper demand and EM imports, particularly out of Asia, which are closely tied to income. EM income growth is expected to remain strong; however, a global trade war, or a significant slowing in trade that reduces investment in EM markets and stymies income growth will be bearish for copper prices. Highlights Energy: Overweight. Going into tomorrow's OPEC 2.0 meeting in Vienna, the Kingdom of Saudi Arabia (KSA) and Russia apparently were divided on how much crude oil production needed to be restored to the market. Increases of as little as 300k to 600k b/d and as much as 1.5mm b/d are flying around the market in the lead-up to the meeting.1 Meanwhile, China threatened to impose tariffs on oil imports from the U.S. if President Trump goes ahead with additional tariffs. The increased Sino - American acrimony on trade issues raises the likelihood China will significantly increase oil imports from Iran, in our estimation, which will exacerbate tensions even further. Base Metals: Neutral. Copper treatment and refining charges (TC/RCs) soared at the end of last week following the closure of India's largest smelter. The Metal Bulletin TC/RC index went to an average of $85/MT at the end of last week, up from $82.25/MT. The pricing service also reported China's primary copper-smelting capacity is lower in June due to environmental constraints. Precious Metals: Neutral. Gold prices dropped below $1,300/oz following the FOMC meeting last week, as Fed officials - e.g., Dallas Fed President Robert Kaplan - nodded toward a fourth rate hike this year, even though his base case remained at three. Ags/Softs: Underweight. Grains and beans are down as much as 10% in the past week, on the back of additional tariffs announced by the Trump administration - 10% on $200 billion worth of Chinese imports. The new tariffs were a retaliatory move by the administration, and represent an escalation of tit-for-tat measures by both sides. Feature Chart of the WeekMajor Drivers of Copper Prices Still Supportive Rising EM incomes and expanding world trade volumes, particularly EM imports, have supported base metals prices for the past two years. This was partly aided by expansionary fiscal and monetary policy in China, the world's largest base-metals market, in 2016, which reversed overly restrictive monetary and fiscal policy in the two years prior. For the most part, these supportive underpinnings are still in place for EM commodity growth over the next two years (Chart of the Week). However, their stability increasingly is being threatened by rising Sino - American trade tensions, and the limited room for credit and fiscal expansion in China.2 Global Copper Demand And Trade In its most recent update of global growth, the World Bank is expecting the rate of growth globally to level off this year and next. However, the Bank expects income growth in EM and developing economies - the growth engines of commodity demand - to go from 4.3% last year to 4.5% this year, and 4.7% next year. EM growth will be dominated by South Asia (Chart 2).3 EM GDP growth is of particular importance to commodity markets, since this constitutes the bulk of commodity demand growth generally, particularly in base metals and oil. For the largest EM economies, the income elasticity of demand for copper is 0.70, meaning a 1% increase in income leads to a 0.70% increase in copper consumption. The Bank notes, "The seven largest emerging markets (EM7) accounted for almost all the increase in global consumption of metals, and two-thirds of the increase in energy consumption" over the past 20 years.4 In what the Bank refers to as Low Income Countries (LICs) - a grouping of smaller economies loaded with commodity producers - GDP is expected to grow 6% p.a. on average over the 2018 - 2020 period. Chart 2World Bank Expects Solid EM Growth EM GDP growth fuels copper demand. Since 2000, a 1% increase in global copper consumption ex-China translates into an almost 2% increase in high-grade refined copper prices, based on results of our modeling. When we replace ex-China demand with China, we see a 1% increase in China's consumption translates into a 0.75% increase in high-grade copper prices over the 2000 - 2018 interval. China's growth is expected to slow going forward, in the wake of a managed slowdown, and due to the fact that, as its economy evolves, more of its growth will come from services and consumer demand, which are less commodity intensive. GDP growth also fuels trade, and vice versa. The Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. In our modeling, we've found a 1% increase in EM trade volumes translates into a 1.3% increase in high-grade copper prices, an elasticity in line with post-GFC trade growth. The other key variable in our modeling is the broad trade-weighted USD, which remains a highly important variable for copper prices. In both our global copper-demand and EM import volume models for copper prices, the level of the USD is an important explanatory variable - a 1% increase (decrease) in the USD TWIB translates into ~ 3% decrease (increase) in copper prices since 2000 in our estimates.5 Tight Credit Conditions In China Can Weigh On Copper ... We've been expecting China's managed slowdown in 2H18 to be offset by strong global demand, which, all else equal, would keep copper demand fairly stable.6 While we still do not expect a hard landing in China, the slowdown we've been expecting is showing up in weaker industrial production prints, disappointing retail sales in May, and most significantly, regulatory and liquidity tightening weighing on money and credit. Chinese demand makes up ~ 50% of global metal consumption, these markets would be especially vulnerable in the case of a significant slowdown. The fear of a more serious slump is founded on tighter financial conditions restricting capital spending, and GDP growth. Granger causality tests to determine the direction of causation between Chinese monetary variables and copper prices point to causality running from de-trended levels of all four measures of money and credit to copper prices (Table 1).7 Table 1Chinese Credit And Copper Prices: Evidence Of Causality Furthermore, y/y changes in copper prices are more highly correlated with monetary variables expressed in terms of de-trended levels, than with those same variables expressed as y/y growth rates, or impulses (Chart 3). Across the four credit and money measures, this expression yields an average correlation coefficient of 0.56, compared with 0.38 and 0.37 when expressed as y/y growth rates and impulses as a percent of GDP, respectively. Our modeling also indicates that it generally takes two to three quarters for the full effect of a change in China's credit conditions to be transmitted to copper markets. When we restrict the sample size to the period from 2010 to now we get similar results to our longer intervals (Chart 4). However monetary variables are more highly correlated with copper prices in the shorter sample. Chart 3Chinese Credit Leads Copper Prices By 3 Quarters... Chart 4...A Slightly Longer Lead Time Since 2010 Correlations in the period since 2010 average 0.61, 0.57, and 0.45 for the de-trended levels, y/y growth rates, and impulses, respectively. This can be put down to the fact that China's role as a demand market for copper has been steadily growing over this period. Given that between 2000 and 2017, China's share of global copper demand swelled from 12% to 50%, it is only natural that the impact of its domestic economy on global copper prices also increased (Chart 5). Furthermore, the time lag between Chinese monetary variables and copper markets in the more recent sample increased slightly, with money and credit variables leading prices by 9-10 months, compared to 6-8 months in the full sample. Chart 5China's Growing Role In Copper Markets Bottom Line: De-trended Chinese money and credit variables statistically cause, and are correlated with, y/y changes in copper prices. While these relationships have generally strengthened with China's growing role in the demand side of global copper markets, rolling correlations highlight that there are also extended periods of weak correlations, suggesting fundamental factors can overwhelm the impact of China's credit environment on global copper markets, as has been the case for the past two years. ...But Other Factors Can Take Over In estimating the effect of China's money and credit conditions on copper markets, we find that the relationship can be dominated by supply - demand fundamentals, and overall global macro conditions. More specifically, we find that in periods where DM equity markets outperform EM equity markets, the coefficients in our models with y/y copper prices as the dependent variable are on average 13% lower than the full sample period (Chart 6). Similarly, in periods where EM outperforms DM, the models' credit coefficients are on average 15% higher than the full sample period.8 Our modeling indicates the pre-2005 period as well as the post-2015 intervals as periods during which strong copper demand from growing DM economies weakened the long-term relationship between Chinese money and credit variables and copper prices. Given our expectation that DM demand will remain supportive, this will, to some extent, offset the negative implications of the deteriorating credit environment in China on copper demand and prices. Similarly, in periods characterized by backwardated copper markets, the magnitude of the impact of Chinese money and credit variables on copper prices is on average 35% lower than the full sample (Chart 7). On the other hand, when the copper market is in contango, the magnitude of the impact of Chinese financial variables is on average 13% higher than the full sample period. This highlights the importance of physical fundamentals, and the fact that in cases where they deviate from the direction of the Chinese credit environment - such as during a supply shock - the physical fundamentals weaken historical correlation relationships. Chart 6Credit-Copper Relationship Weakens When DM Outperforms EM ... Chart 7... And When Markets Are Backwardated To rank the top explanatory financial variables in terms of their effect on the evolution of copper prices, we estimated regression models with monetary variables, along with the broad trade-weighted U.S. dollar, and world excluding China copper demand as independent variables (Table 2). Table 2USD Usually Dominates Copper's Evolution The results, which can be interpreted as the y/y percentage point (pp) change in copper prices from a one y/y pp increase in each of the three explanatory variables, indicate that Chinese credit has a similar effect as a one y/y pp increase in world excluding China copper demand, a not-unexpected result, given the rest of the world accounts for 50% of demand. On the other hand, the USD has an outsized effect on the copper market. In our modeling, we've found that, in general, a one pp increase (decrease) in the broad trade-weighted USD translates into a one pp change in copper prices, using y/y models.9 Will Copper Vs. USD Correlations Return To Equilibrium? Our House view calls for a stronger USD going forward. Despite our expectation that DM demand will remain supportive, absent supply-side shocks, a stronger USD along with deteriorating credit conditions in China will weigh on copper prices.10 Ongoing trade disputes will only further bear down on the copper market. Stronger EM GDP growth and the associated increase in copper consumption and trade volumes will offset the strong-USD effects, but a trade war would undermine this support. A caveat to this conclusion is that while credit growth has been generally restrained, the Chinese government - fearful that its policy measures to date are spiraling out of control - may partially reverse its efforts and attempt some easing.11 Bottom Line: The impact of Chinese credit conditions on copper prices is weakened in periods where DM stock prices outperform EM, and when the copper forward curve is backwardated. In terms of the relative magnitude of the effect of China's credit conditions, we find that it has a similar sized effect as the rest of the world's copper demand on the red metal's price, while the USD has a relatively larger effect. This implies that a stronger USD, coupled with tighter financial conditions in China, will compete with expanding EM GDPs and trade growth going forward. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 OPEC 2.0 is the name we've coined for the oil producer coalition lead by KSA and Russia. In November 2016, the coalition agreed to remove 1.8mm b/d of production. We estimate actual production cuts amount to 1.2mm b/d, while as much a 1.5mm b/d of production has been lost to depletion and a lack of maintenance drilling (e.g., infill and other forms of enhanced oil recovery). 2 Our colleague Peter Berezin, writing in this week's Global Investment Strategy, noting slowing industrial production, retail sales and fixed-asset investment, observes, China's "policy response has been fairly muted." Further, unlike 2015, when China stimulated its economy and lifted EM generally, this go-round, there is less room to maneuver owing to high debt levels and overcapacity. Please see BCA Research Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global risk Assets To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 3 Please see "The Role of Major Emerging Markets in Global Commodity Demand" in the Bank's Global Economic Prospects, June 2018, beginning on p. 61. 4 The Bank's EM7 are Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey. They account for ~ 25% of global GDP, and some 60% of global metals consumption. The income elasticities of aluminum and zinc demand for this group are 0.80 and 0.30, respectively. Please see Table SF1.1 on p. 70 of the Bank's June report. 5 The R2 statistic measuring the goodness of fit between actual copper prices and the modeled prices is 94% for the copper-consumption model, and 96% for the EM trade model over the 2000 - 2018 interval. The USD TWIB was used as an explanatory variable in both models. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. 7 Given that in levels, the money and credit variables display a deterministic upward trend, we removed the trend from the data in order to isolate the fluctuations around this trend. This de-trended series is what is significant to copper demand, and thus the evolution of copper prices. 8 We use a threshold OLS model to estimate the y/y model coefficients. The average change in the value of the coefficient is based on the coefficients in the models' outputs of the four money and credit measures. 9 The R2 statistics measuring the goodness of fit between actual y/y changes and those estimated in our models were ~63% in all four models. 10 We discussed this at length last week in BCA Research Commodity & Energy Strategy Weekly Report "Correlations Vs. USD Weaken," dated June 14, 2018, available at ces.bcaresearch.com. 11 Some preliminary signs of potential easing include (1) the PBOC's most recent monetary policy decision in which it did not follow the US Fed's interest rate decision by hiking rates, as it generally does, and (2) a reduction in the reserve requirement ratio. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in
Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Chart 8Trump's Tariffs On China We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Chart 11Car Imports? What Imports? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Chart 16Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar