Emerging Markets

Highlights So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall.  Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 15...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Geopolitical Calendar  

Chart Of The WeekEM Profits Contraction Today we are publishing a review of domestic demand conditions in each of the 22 emerging economies we cover. Domestic demand growth is either sluggish, decelerating or contracting in the overwhelming majority of countries. This is in addition to the export contraction currently taking place in many EMs. Consistently, EM overall EPS and small-cap EPS growth rates have fallen to zero in local currency terms (Chart Of The Week). In U.S. dollar terms, overall EM EPS are contracting. The recent dollar weakness versus EM currencies has allowed some EM central banks to cut rates. However, we expect the greenback to strengthen, as we elaborated in last week's report, and that will prevent central banks in high-yielding EMs from easing monetary policy further. Hence, a domestic demand revival in EM is not imminent. We reiterate our negative stance on EM currencies and risk assets. China: Consumer Is Mixed; Capex Is Weak Chart I-1 Chart I-2 India: Domestic Demand Is Decelerating Chart I-3 Chart I-4 Indonesia: Domestic Demand Is Very Weak Chart I-5 Chart I-6 Malaysia: Is The Downturn Late? Chart I-7 Chart I-8 Singapore: Domestic Demand Is Contracting Chart I-9 Chart I-10 Thailand: Stable Domestic Demand Growth Chart I-11 Chart I-12 Philippines: From Boom To Bust? Chart I-13 Chart I-14 Korea: Exports Recession Will Dampen Domestic Demand Chart I-15 Chart I-16 Taiwan: Moderate Domestic Demand Growth Chart I-17 Chart I-18 Vietnam: Robust Domestic Demand Chart I-19 Chart I-20 Brazil: The Economy Needs Stimulus Chart II-1 Chart II-2 Chart II-3 Chart II-4 Mexico: Heading Into A Mild Recession? Chart II-5 Chart II-6 Chile: Heading Into A Recession? Chart II-7 Chart II-8 Chart II-9 Argentina: As Bad As It Gets? Chart II-10 Chart II-11 Chart II-12 Chart II-13​​​​​​ Colombia: Entering Another Downtrend Chart II-14 Chart II-15 Chart II-16 Peru: External Sector Drives Credit Cycle Chart II-17 Chart II-18 South Africa: More Downside Ahead? Chart III-1 Chart III-3 Chart III-2   Turkey: As Bad As It Gets? Chart III-4 Chart III-5 Chart III-6 Chart III-7 Russia: Sluggish Economy Chart III-8 Chart III-9 Chart III-10 Central Europe: Strong Demand/Weak Manufacturing Chart III-11 Chart III-12   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Bank Credit Analyst

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Chart II-1 (ANASTASIOS)The 1998 Episode Revisited Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I)   Chart II-14 (PETER)The Dollar Is A Countercyclical Currency Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). 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. 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. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart II-15 (ANASTASIOS)Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Chart II-19 (ARTHUR)China And EM Profits Are Contracting Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps Chart II-21 (ANASTASIOS)Buy Hypermarkets   Chart II-22 (ANASTASIOS)Stick With Managed Health Care This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds   Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… …And The Bears Footnotes 1       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5     France is a good proxy for the euro area. 6     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.

Bank Credit Analyst

Highlights Global inflation will slow further, allowing central banks to ease policy. Liquidity indicators will have more upside as monetary policy will remain accommodative. Widening fiscal deficits, easing Chinese credit trends and rising U.S. consumer real income levels, all will allow improved liquidity to boost global growth in the second half of 2019. Important indicators are already flashing an increase in global growth. Yields have upside; keep a below-benchmark duration within bond portfolios. Commodity plays will perform well. The 12-month outlook for stocks remains positive, but they will churn over the coming six months. Equities will nonetheless outperform bonds. Favor cyclicals over defensives and international equities over the U.S. Feature Treasury yields are stuck near 2%, yet the S&P 500 is flirting with all-time highs. Investors are worried about global growth, still hoping that central banks will step in. The fears are well-placed: manufacturing has not stabilized, Asian trade is contracting, and the U.S. real estate sector is in the doldrums. Other concerns include the threat of U.S. President Donald Trump re-igniting the trade war and the U.S. corporate sector’s growing debt load. The positive news is that global inflation will remain low for the next 12 months or so. Without prices accelerating upward, global policymakers will continue to ease monetary and fiscal conditions. Consequently, nascent improvements in global liquidity conditions will blossom and growth will rebound in the second half of the year. Increased growth creates a paradox. At current levels, it is bearish for bonds and bullish for commodities. However, stock valuations will be undermined by higher bond yields, especially because earnings should experience additional downside this year. Consequently, the S&P 500 will churn sideways for the coming three to six months before taking off. In the meantime, stocks should outperform bonds. Blessed By Low Inflation The best news for the global economy is that inflation will stay low. Our U.S. Bond Investment Strategy colleagues recently showed that when the private sector does not quickly build large debt loads, rising inflation prompts all the post-war recessions.1  Today, the private sector’s debt vulnerability is limited. Nonfinancial private-sector leverage has only expanded by 2.1 percentage points of GDP since its trough four years ago (Chart I-1). In particular, after a drop from 134% to 106%, the household sector's debt-to-disposable income ratio has flat-lined for the past three years. Meanwhile, household debt-servicing costs as a percentage of after-tax income are at multi-generational lows. Even in the corporate sector, excesses are smaller than they appear. Despite accumulating US$5 trillion in credit since 2009, the nonfinancial corporate sector’s debt-to-asset ratio remains below its historical average of 22.4%. This sector is also generating free cash flows equal to 2.1% of GDP. Prior to recessions, the corporate sector consumed cash instead of generating it.2 Chart I-1No Excessive Debt Built-Up In The U.S. In this context, we are optimists because inflation is set to slow, leaving policymakers around the world a window to maintain generous monetary conditions and support growth. At the global level, we currently see a paucity of inflation. Among advanced economies, average core inflation is only 1.5%. Moreover, only 15% of these nations are experiencing rates of underlying inflation above the critical 2% level (Chart I-2). Chart I-2Global Inflation Will Stay Tame Going forward, risks are skewed toward a deceleration in prices. Inflation is the most lagging economic variable. Thus, the recent global economic slowdown will continue to exert downward pressure on prices. Singapore, a country highly dependent on trade, is an excellent barometer for global cyclical sectors. In the second quarter of 2019, Singapore’s annual GDP growth declined to 0.1%, its lowest level since the Great Financial Crisis. Historically, this has presaged a marked deceleration in global core CPI (Chart I-2, bottom panel). The weakness in global inflation also will translate into lower U.S. underlying inflation. U.S. import prices (excluding oil) are contracting by 1.4% on an annual basis. Despite U.S. tariffs, import prices from China are also shrinking by 1.5%, the deepest retrenchment since the deflationary scare of 2016. This will weigh on the price of U.S. goods. U.S. activity suggests imported disinflation will spill over into overall core CPI. Since 2009, the changes in the ISM manufacturing index and the annual performance of transport stocks relative to utilities have led core inflation (Chart I-3). Based on these relationships, core CPI should slow markedly. Pipeline inflation measures suggest this is a fait accompli. Core crude producer prices are melting, signaling lower inflation excluding food and energy. Chart I-3Deflationary Forces In The U.S. As Well Finally, there is only a slim chance that inflation will exceed 2.5% in the coming year, according to the St. Louis Fed’s Price Pressure Measure (Chart I-4, top panel). Import prices point toward lower goods prices, while core service CPI is quickly slowing and medical care CPI remains close to 2%, which is near record lows (Chart I-4, second panel). Meanwhile, shelter CPI shows little upward momentum (Chart I-4, third panel). Finally, the rebound in productivity growth to 2.4% is also limiting the inflationary impact of rising wages: unit labor costs are contracting at a 0.8% annual rate, despite a 3.1% year-over-year expansion in average hourly earnings (Chart I-4, bottom panel). Chart I-4Details Of U.S. CPI Evidence, therefore, points to inflation slowing down in advanced economies, even in the more robust U.S. Opening The Liquidity Spigots The lack of inflation allows central banks to ease policy in response to the slowdown in global growth. The Fed is set to trim rates by 25 basis points next week and again later this year. The ECB just telegraphed a rate cut and potentially a resumption of its QE program for September. The Reserve Bank of Australia has chopped rates twice this year, and the Reserve Bank of New Zealand, one time. Meanwhile, the People’s Bank of China has slashed the reserve requirement ratio (RRR) by 3.5% in the past 15 months. The Fed’s interest rate cuts are crucial for U.S. growth and emerging market liquidity conditions. Money moved into EM economies as interest rate markets priced in ever-deeper U.S. rate cuts after the Federal Open Market Committee’s dovish pivot this winter. As a result, EM currencies stabilized, allowing EM central banks to ease policy to support their sagging domestic economies. The Bank of India, the Bank of Indonesia, the Bank of Korea, the South African Reserve Bank, the Bank of Russia, Bank Negara Malaysia, and the Turkish Central Bank have all cut rates. Central banks in Brazil and Mexico are expected to follow suit.  Global policy easing should solidify an improvement in many global liquidity indicators and thus, support global growth in the next year: M2 growth in the U.S. bottomed last November. Concurrently, the growth of money of zero maturity in excess of credit has improved since late last year. This sends a positive signal for BCA’s Global Nowcast, BCA’s Global LEIs, and global and Asian export prices (Chart I-5). Chart I-5More Excess Money, More Activity Our U.S. Financial Liquidity Index continues to accelerate, corroborating the message about global growth conditions from our excess-money indicator (Chart I-6). Chart I-6Improving Global Liquidity Conditions Emerging Markets’ M1 is turning up, albeit at a depressed level. This improvement will likely morph into a recovery as EM and DM central banks ease policy. EM M1 has excellent leading properties on EM activity and profits. Gold, a traditional reflation gauge, has broken out as real rates remain depressed. Finally, TED spreads, both on a spot and a three-month forward basis, have tumbled to near all-time lows (Chart I-7). Plentiful global liquidity narrows these spreads. Moreover, their tightness indicates that there is minimal stress in the financial system. Also, TED spreads were more elevated and getting wider before previous recessions, during the euro area crisis and even during the 2015-16 slowdown. Chart I-7No Stress In TED Spreads Low inflation allows monetary authorities to nurture an improvement in liquidity, which would raise the odds that the cycle should soon bottom. Global Growth Indicators In addition to a supportive liquidity environment, important developments point toward a meaningful global growth pick in the second half of the year. At first glance, data continues to deteriorate. Aggregate capital goods orders in the U.S., Japan, and Germany are contracting at a 7.3% annual pace, the flash PMI numbers released this week were poor and the U.S. LEI shrunk last month on a sequential basis and only increased 1.6% year-on-year. However, these data points miss crucial undercurrents. Governments normally loosen fiscal policy – as measured by the changes in cyclically-adjusted primary balances – after a recession has begun. This time, governments are already expanding deficits. In the euro area, the fiscal thrust is moving from -0.3% of GDP to 0.4% of GDP, a 0.7% of GDP boost to growth compared to last year. In China, fiscal deficits are deepening. In response to large tax cuts and expanding subsidies to various sectors, Beijing’s official budget hole has grown from 3.7% of GDP in 2017 to 4.9% this year. Broader measures, which include provincial and local governments, and off-balance-sheet entities, recorded a deficit of 11% this year. In Japan, the government is implementing fiscal offsets as large, if not larger, than the upcoming VAT increase. Even in the U.S., fiscal policy will probably ease. The Congressional Budget Office tabulates a fiscal drag of 0.5% of GDP in 2020 because of the 2011 Budget Control Act. However, the national debt was set to hit its ceiling soon. In response, the GOP and the Democrats have agreed to a proposed funding measure that will ultimately boost spending by US$50 billion more than the previously tabulated fiscal retrenchment (Chart I-8). Chinese credit policy is also increasingly supportive of global growth. Adjustments to the RRR normally take approximately 12 months to affect China’s adjusted total social financing (TSF) (Chart I-9, top panel). Changes to the RRR also lead global industrial activity, albeit more loosely, by 18 months (Chart I-9, second panel). This last relationship exists because soon after the TSF expands, Chinese economic agents use the proceeds to invest or spend on durable goods. This process boosts Chinese imports and lifts global economic activity (Chart I-9, bottom panel). Moreover, as we argued last month, we expect China’s reflationary efforts to continue for the rest of the year.3 Chart I-9The Impact Of The Chinese Stimulus Is Only Starting To Be Felt China’s stimulus is showing early signs of working, despite regulatory constraints on the banking sector. Construction and installation spending by Chinese real estate firms troughed in June 2018 and are growing at a 5.4% annual pace. The growth of equipment purchases is a stunning 22%, near its highest yearly rate in three years. Additionally, China’s intake of steel and cement is surging. These developments normally materialize ahead of rebounds in the PMI or the Li-Keqiang index. Even the outlook for China’s auto sales may be improving. Vehicle sales in China fell by 15.8% in May. In June, they remained soft despite heavy discounts by auto manufacturers. However, vehicle inventories are falling, indicating that auto production is poised to pick up. Importantly, real income levels for U.S. consumers are on the rise. Real average hourly earnings are growing by 1.8% year-on-year, the highest in this cycle. This is a dividend from the recent uptick in productivity (Chart I-10). Mounting productivity both puts a lid on inflation and enhances real incomes. Chart I-10Productivity Is The Name Of The Game Additional developments warrant optimism over global growth: The performance of EM carry trades funded in yen is rebounding. Historically, this has been a reliable leading indicator of global industrial activity (Chart I-11, top panel). As carry traders buy EM currencies and sell the yen, they borrow funds from an economy replete with excess liquidity and savings (Japan) and inject them where they are needed to finance investment and consumption (the EM). In the process, they bid up EM currencies and inject liquidity in those countries, supporting growth conditions globally.  Chart I-11Positive Signs For Growth The annual performance of the sectors most sensitive to global growth conditions – global semi, industrials and materials stocks – is bottoming relative to the broader market. Normally, this happens ahead of troughs in BCA’s Global Nowcast (Chart I-11, middle panel). European luxury stocks are performing strongly, which also usually precedes rebounds in global economic activity (Chart I-11, bottom panel). Shipping costs are moving up. The Baltic Dry Index, a measure of the cost of shipping commodities, has surged by 270% since February 2019 to its highest level since 2013. Some have argued this gauge overstates the economy’s potential strength. However, the Harpex index, a measure of the cost of shipping containers, has risen by 30% in the same period. This concurrence of moves suggests that the Baltic Dry is probably correct about the direction of growth, but might be overstating the size of the rebound. Our composite momentum indicator for ethylene and propylene – two chemicals that enter into the production of pretty much everything that makes the modern economy work – is forming a bullish price divergence (Chart I-12). The price of these chemicals normally rises when global growth accelerates. Chart I-12Chemical Technicals Point To A Rebound Bottom Line: Global growth should be buoyed by several indicators, specifically a low inflation environment, an easing in both monetary and fiscal policy, a positive outlook for already improving global liquidity conditions, a healthy U.S. consumer, and the lagged impact of China’s stimulus. Investment Implications: Strong Crosscurrents For Stocks Bonds At this juncture, bonds may be the easier asset class to call; a below-benchmark duration is appropriate for fixed-income portfolios. Pessimism towards global growth is most evident in the prices of safe-haven assets. According to the CFTC, asset managers’ net-long positions in all forms of listed Treasurys contracts are hovering near all-time highs. This makes bonds vulnerable to positive economic surprises. The long-term interest rate component of the ZEW survey corroborates this message. Expectations for global long-term interest rates are near record lows. If a recession is avoided, then readings this low offer a powerful contrarian signal for bonds (Chart I-13). Chart I-13Bonds: A Contrarian Bet A potential uptick in growth would confirm this bond-bearish setup. The improvement in Chinese TSF and the strength in European luxury goods makers point towards higher yields (Chart I-14). Bond prices would also suffer if the average price of ethylene and propylene can heed the bullish signal from its momentum oscillator. Moreover, in the post-war era, on average Treasury yields typically bottomed 12 months ahead of inflation. Chart I-14Cyclical Dynamics Point To Higher Yields Given that bonds are expensive, there is a greater likelihood that positioning and cyclical forces will push up yields. Our bond valuation model shows that Treasurys are expensive and various estimates of global term premia have never been this negative. This reflects the belief that policy rates will stay low forever. However, if global growth picks up, then the Fed is highly unlikely to cut rates over the coming 12 months by the 90 basis points currently discounted by the OIS curve. Moreover, stimulating at this point in the cycle increases the risk of generating inflation down the road. Accelerating inflation would ultimately force global central banks to boost rates in the next three to five years by much more than expected, warranting higher term premia around the world. Therefore, we expect inflation expectations and term premia – but not real rates – to drive up yields, at least until global central banks abandon their dovish biases. Commodities Commodities and related assets are attractive. A measure of growth sentiment based on futures positioning in stocks, oil, copper, the Australian dollar and the Canadian dollar relative to bets on Treasury of all maturities and the dollar index shows that investors have not moved into commodity plays (Chart I-15). Moreover, traders who manage money on behalf of clients are also massively short copper, one of the most growth-sensitive commodities (Chart I-16). Chart I-15Investors Are Not Positioned For A Rebound In Growth Chart I-16Copper Is An Attractive Bet For A Growth Rebound The six-month outlook is particularly positive for the Australian dollar. The RBA has already moved aggressively to ease policy and the purging of excesses in the Australian economy is well advanced. Property borrowing for investments has collapsed by 35%, housing activity has contracted by 22%, and building permits have fallen by 20%. However, the Australian labor market remains robust and early indicators of real estate activity in major cities are stabilizing. External forces are also positive for the AUD. Strong steel prices, which have contributed to the rally in iron ore, coupled with quickly growing Australian LNG exports, will boost the terms of trade for the AUD. Moreover, the rebound in Chinese TSF, which we expect to gather momentum, creates another tailwind (Chart I-17, top panel). What’s more, rising ethylene and propylene prices, as well as rallying stock prices of European luxury goods makers, are strong supports for commodity currencies (Chart I-17, second and third panel). Chart I-17The AUD Looks Increasingly Interesting Silver is another attractive play. Last month, we argued that easy global policy would create an important support for gold.4 Since then, silver has broken out of a downward sloping trend line in place since 2016. Unlike gold, silver is still trading near very depressed levels (Chart I-18). Moreover, according to net speculative positions, gold is overbought on a tactical basis and ripe for a pullback, whereas silver is not nearly as popular with speculators. Our optimistic stance on global growth is congruent with an outperformance of silver relative to gold. Silver has more industrial uses than gold and the gold-to-silver ratio generally falls when manufacturing activity perks up. Chart I-18Silver To Shine Brighter Than Gold Equities The window to own stocks remains open. Stocks have more upside on a 9- to 12-month basis, but are set to churn over the coming three to six months. The risk of sharp but temporary corrections is elevated. Stocks rarely enter a bear market if a recession is far away. Stock prices perform well in the 12 months prior to the last half-year before a recession begins (Table I-1). If we expect growth to pick up over the next 6 to 12 months and policy to remain easy, then a recession will not occur before late 2021/early 2022. The improvement in our global liquidity indicators also supports a period of strong equity performance ahead (Chart I-19). Moreover, the 2-year/fed funds rate yield curve is inverted. Since the 1980s, after such inversions, the median 12-month return for the S&P 500 has been 14%. Stripping out recessionary episodes, the median returns would have been 18.6%, 13.1%, and 9.9%, over 12, 6 and 3 months, respectively (Table I-2). Chart I-19Liquidity Will Put A Floor Under Stock Prices Technically, stocks are also on a strong footing. The equal-weight S&P 500 has broken out, indicating robust breadth. Our composite sentiment indicator for U.S. equities is not flagging any euphoria among market participants (Chart I-20). BCA’s Monetary, Technical and Intermediate Indicators show one should own stocks. Chart I-20BCA's Indicators Favor Stocks Nevertheless, important negatives for stocks also exist. The rally in equities has been fueled by hope, as our U.S. Equity Strategy team has highlighted. Since December 2018, the rally has been driven by multiples expansion (Chart I-21). Meanwhile, Section II’s debate shows that Anastasios’s earnings models all point to low earnings growth later this year. The weakness in core crude producer price inflation will weigh on margins and corporate profits (Chart I-22). It will therefore become increasingly difficult to justify widening P/E ratios. Furthermore, the S&P 500 has moved well ahead of the performance implied by earnings estimates revisions (Chart I-23).5 Chart I-21Multiples Inflation Chart I-22Profits Still Face Near-Term Hurdles Chart I-23EPS Revisions And Stock Prices Have Dissociated From a valuation perspective, the S&P’s price-to-book, price-to-sales, or cyclically adjusted P/E ratio, all are demanding by historical standards, but justifiable if Treasurys only offer a 2% yield. This rally based on hope is vulnerable to our expectations of higher yields. Only once earnings rebound, which will pull down multiples in a benign fashion, can stocks resume their uptrend. U.S. stocks will probably churn for the rest of the year. The media made much of the S&P 500 hitting new highs in September last year and this month, but the U.S. benchmark is only 3.5% above its January 2018 peak. U.S. stocks have been very volatile, but have gone nowhere for 18 months; this pattern should hold. We are overweight stocks relative to bonds given that we recommend maintaining a below-benchmark duration for fixed-income portfolios. At 1.9%, the S&P 500 dividend yield is in line with the yield to maturity of 10-year Treasurys, while the wide equity risk premium suggests that stocks are a bargain compared to bonds. Also, the stock-to-bond ratio performs well when global industrial activity rebounds (Chart I-24). Chart I-24If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... Cyclical stocks will likely outperform defensive equities on rebounding global growth. The bullish configuration in the price of chemicals is consistent with a period of outperformance for cyclical equities (Chart I-25). Cyclicals also perform well when yields are moving higher, especially when central banks remain accommodative. A positive view on commodities fits within this pattern. Chart I-25...And Cyclicals Outperform Defensives European stocks are better placed than their U.S. counterparts in the coming six to nine months. European stocks outperform U.S. ones when the Chinese TSF moves up (Chart I-26), reflecting their higher sensitivity to the global business cycle. Additionally, European equities are trading at a large discount. The forward P/E and price-to-book of an equally weighted average of European stocks stand at 14.4 and 2.1 respectively, versus 20.7 and 4.1 for the U.S. Chart I-26Look Into Upgrading Europe At The Expense Of The U.S. Loan volumes will benefit from the large easing in European financial conditions resulting from the 166-basis-point drop in peripheral yields this year, with BTP yields falling to a near three years low following the ECB’s dovish tilt. This will remove some of the negative impact of soft net interest margins on bank profits. European banks could be an attractive trade. Finally, global auto stocks are trading at their lowest levels relative to the global equity benchmark since the beginning of the 2000s (Chart I-27). Moreover, global auto stocks trade at 44% discount to the broad market on a 12-month forward P/E basis, the largest handicap since 2009. This sector should perform well in the next year based on purged global auto inventories, robust consumer real income, falling interest rates and rebounding global growth. Chart I-27Autos Are A Contrarian Play Mathieu Savary Vice President The Bank Credit Analyst July 25, 2019 Next Report: August 29, 2019   II. What Goes On Between Those Walls? BCA’s Diverging Views In The Open BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.6   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). Chart II-1 (ANASTASIOS)The 1998 Episode Revisited With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). 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 II-14 (PETER)The Dollar Is A Countercyclical Currency 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. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Chart II-15 (ANASTASIOS)Gravitational Pull Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Chart II-19 (ARTHUR)China And EM Profits Are Contracting Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-21 (ANASTASIOS)Buy Hypermarkets This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Chart II-22 (ANASTASIOS)Stick With Managed Health Care Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (II) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (I) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… …And The Bears ​​​​​​   III. Indicators And Reference Charts The S&P 500 has limited cyclical downside for now, however, the short-term outlook is more troublesome. U.S. stocks are hovering near all-time highs, but they are not showing much conviction. Positive catalysts have moved into the rearview mirror now that a flurry of central banks have also cut rates, that it is certain that the Fed will cut rates next week, and that the ECB will follow in September. A volatile churning pattern will likely prevail over the coming three months. Our Revealed Preference Indicator (RPI) points to short-term risks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuation and policy, investors should lean against the market trend. A pick-up in global growth is needed to help earnings, which would cheapen valuations enough to clear the short-term clouds hanging over the stock market. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it is slightly deteriorating in Europe. The WTP indicator tracks flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips, creating a floor under stock prices in the process. Our Monetary Indicator continues to move deeper into stimulative territory, supporting our cyclically constructive equity view. Global central banks are easing policy in unison, creating very accommodative liquidity conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory. However, it is not elevated enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator continues to move further above its 9-month moving average. These dynamics confirm that equities have more cyclical upside and that dips should be bought. According to our model, 10-year Treasurys are now as expensive as at any point over the past five years. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Various rate-of-change measures for bond prices are flashing extremely overbought conditions as well. Additionally, duration surveys, positioning data, and sentiment measures are all showing that investors expect nothing but low yields. Considering this technical backdrop, BCA’s economic view implies that yields are likely to have bottomed earlier this month. On a PPP basis, the U.S. dollar remains very expensive. Additionally, our Composite Technical Indicator has formed a negative divergence with prices. The dollar’s recent strength could set it up for a substantial decline. If the dollar’s Technical Indicator falls below zero, the momentum-continuation behavior of the greenback will kick in. The USD would suffer markedly were this to happen. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals​​​​​​​ COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Please see U.S. Bond Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence,” dated April 23, 2019, available at usbs.bcaresearch.com 2       The biggest concern with debt sustainability is the distribution of the debt. Aggregate ratios are currently flattered by the low debt loads and high cash holdings as well as cash generation power of the tech sector. Nonetheless, the low level of aggregate debt accumulation by the entire private sector, including households, points to a limited cyclical vulnerability to the economy created by leverage. However, this also means that a more-severe-than-usual default wave is likely to materialize outside the tech sector once a recession emerges. 3       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 4       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Divorced From Reality,” dated July 15, 2019, available at uses.bcaresearch.com 6       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 7       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 8       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 9       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 10     France is a good proxy for the euro area. 11     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Six months into a credit expansionary cycle, China’s economic recovery remains fragile. Lack of government support for the auto and property sectors is undermining a cyclical recovery. Accommodative monetary policy is not enough to lift the Chinese economy out of its doldrums, particularly as households and companies remain restrained in levering up and spending. Fiscal policy has become more proactive this year by front-loading local government bond financing in the first half of 2019. But if policymakers are to stick to their budget deficit target for the year, the second half of the year will see fiscal tightening. Early signs suggest China is positioning for a further loosening of fiscal spending. However, the Chinese leadership will likely only allow limited additional stimulus this year, resulting in a “W-shaped” economic trajectory for the rest of 2019. In the near-term, the risk to Chinese equity underperformance is high. But over the coming 6-12 months, odds are that the economy will have weakened enough for the Chinese government to make concerted efforts to stimulate. An overweight stance on Chinese stocks is hence warranted over that time horizon. Feature China’s credit growth bottomed in December last year. Six months later, however, China’s economy is showing few signs of emerging from the woods: official GDP growth in the second quarter of this year rang in at its lowest pace in 27 years. Our monthly gauge of China’s business activity, after a brief improvement earlier this year, has flat-lined. The growth of investable earnings per share has fallen into negative territory (Chart 1).More concerning, however, is that manufacturing output has been trending straight down following a first-quarter blip (Chart 2). Chart 1Not Yet Out Of The Woods Chart 2Turning The Corner In Q3? As we mentioned in our July 10th, 2019 China Investment Strategy Weekly,1 while keeping monetary policy accommodative, China’s central bank has not been particularly proactive at significantly stimulating the economy. We believe the People’s Bank of China will continue to sit on the sidelines until the economy deteriorates further, and until they receive more clear guidance from China’s top leadership. The Politburo mid-year economic review meeting in late July will likely shed some light on any upcoming policy shift. In the meantime, fiscal policy has taken a more proactive role in supporting the economy this year: unprecedented tax cuts that account for about 1.7% of GDP started on January 1st, and local government bond issuance accelerated in the first half of 2019 relative to the past two years (Chart 3). Nevertheless, reflationary efforts in the past six months measured by aggregate credit growth as a percentage of nominal GDP have been “half-measured” compared to previous credit expansions. As a result, it is taking longer for China’s economy to find its footing.  The Missing Two “Prongs” It is convenient to blame the ongoing U.S.-China trade war for the sluggishness in the Chinese economy, especially in the manufacturing sector. But in our view, the trade war has only magnified what was already a weak and deteriorating domestic Chinese economy due to previously tight policy.2 What’s more, the magnitude of the stimulus so far has not been large enough to fully reverse the decline in Chinese domestic demand growth. The imbalances in China’s “old economy” have also stymied the effectiveness of the stimulus. Among the three “prongs” that supported a “V-shaped” economic recovery in 2015-2016 (stepped-up infrastructure spending, and support for the auto and real estate sectors), the latter two have been missing in the current episode3: Automobile. Both car sales and production have been contracting for almost a year. The contractions deepened in the second quarter from the first quarter, despite accommodative monetary and credit conditions. This is in sharp contrast from what happened in the 2015-2016 cycle: As credit growth picked up in mid-2015, year-on-year growth in auto sales and production both turned positive three months later and stayed mostly in positive territory until 2018 (Chart 4). Chart 4Auto Sector Has Not Responded To Stimulus Chart 5ALess Demand For Autos BCA’s Emerging Markets Strategy team has written at length on this topic.4 From their lens, both secular and cyclical factors have contributed to this year’s auto sector slump: First, a sharply higher automobile ownership rate in recent years has cyclically reduced household demand for cars (Chart 5A); Second, the central government has only allowed regional governments to loosen up policy restrictions on automobile purchases and license applications, as opposed to providing monetary incentives through sales tax reductions and subsidies in both 2009 and 2016. Another important contributing factor to depressed auto sales is the constraint on Chinese households’ balance sheets (Chart 5B). The rapid growth in mortgage and consumer borrowing from 2015-2017 has pushed Chinese household debt to nearly 120% of disposable income, higher than that in the U.S. (Chart 5C). Chart 5BSlower Pace In Leveraging For Chinese Households... Chart 5C...Following A Borrowing Binge Real Estate. The real estate sector was another “prong” that was crucial to the 2015-2016 cyclical recovery in China’s economy. Property sales picked up sharply in 2015, along with ballooning mortgage loans (Chart 6). In this cycle, however, housing sales have been sluggish, and real estate developers have been struggling to complete projects they have started (Chart 7). The three factors that drove property demand in 2015-2017 are now absent: Chart 6Property Market Was Red Hot In 2015-2016 Chart 7The Party Did Not Repeat In Current Cycle Skyrocketing mortgage lending. As mentioned above, the acceleration in household leveraging is unlikely to repeat in the current cycle. Real estate developers’ access to funding was the key to the strength of construction activity in the property market in 2016. Presently, real estate developers lack access to credit, including financing through shadow banking (Chart 8A). The China Banking and Insurance Regulatory Commission (CBIRC) has stepped up in real estate financing regulations and supervisions: It recently issued window guidance to curb certain borrowing activities among real estate developers in the offshore market, and also from obtaining financing through shadow banking domestically. Government subsidies are missing. Most importantly, subsidies from China’s central bank to the real estate sector was another key pillar of support for the property boom in the previous cycle. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Supplementary Lending5 (PSL) facility designed for slum area reconstruction.6 As of June, PSL has remained deeply in negative territory for 11 straight months (Chart 8B). Chart 8ARestrictive Lending Environment Unlikely To Change Soon Chart 8BGovernment Subsidies Are Missing The high level of leverage in both the household and property sectors have been focal points in the Chinese leadership’s financial deleveraging and de-risking campaign. Indeed, the restrictive financing environment for both sectors reflects the Chinese authorities’ determination to curb excessive borrowing and speculation in the housing market. Bottom Line: Two of the three impetuses that supported the upswing in the Chinese economy in 2015-2017 – auto sales and real estate – have so far been subdued or have acted as a drag on the economy in the current cycle. China will have to rely on the third pillar – infrastructure spending – to support the economy. Fiscal Policy “China will continue to implement a proactive fiscal policy, a prudent monetary policy and an employment-first policy, while making good use of counter-cyclical regulation tools and carrying out anticipatory adjustments and fine-tuning when necessary.” - Premier Li Keqiang, July 15, 2019. Fiscal policy has been proactive this year, but so far has failed to catalyze a recovery in investment spending. More importantly, the existing institutional framework on fiscal policy suggests that unless the Chinese government is willing to remove budgetary constraints, we will see fiscal tightening in the second half of the year. During the first half of this year, 70% of 2019’s total budgeted local government bonds were issued, double the amount issued in the same period last year.7 According to the Ministry of Finance, 65% of total local government bonds issued (including both general and special-purpose bonds) were invested in infrastructure projects.8  However, the growth figure for fixed-asset investment (including infrastructure) for the first six months of 2019 was the weakest in the past five years. The considerable deceleration in infrastructure investment since late 2017 can be attributed to three factors: a.  Sharply shrinking shadow banking. Local government spending has been stymied by the central government’s financial deleveraging efforts (Chart 9A). This affects both on-book fiscal spending and off-book spending by local government financing vehicles (LGFV). Although the exact impact on the latter is hard to quantify, the cracking down on shadow banking, a major financing channel for LGFV, coincides with the peak of infrastructure investment growth. Chart 9AShadow Banking Was A Crucial Funding Source For Infrastructure Investment Chart 9BA Thinner Wallet This Year   b.  Lower government revenue. Sluggish land sales have undermined local governments’ revenue streams. Land sales account for three quarters of local government revenue. Chart 9B shows that both land sales and government revenue decelerated in mid-2018, as lending conditions for the property sector became restrictive. In addition, as part of its fiscal stimulus efforts, the Chinese authorities stepped up on tax cuts to businesses and individuals this year. Tax cuts are estimated to augment the government’s 2019 deficit by 0.2 percentage points of GDP. As a result, government revenue from tax income in the first half of 2019 only grew by 0.9% year-on-year, way below the 14% growth clocked last year (Chart 9B, middle panel). By law, local governments cannot exceed their annual budgetary deficit by more than their quote of general purpose bond issuance. Lower revenue from slower land sales and tax cuts have impeded local governments’ spending capabilities. A bigger concern for investors is that the Chinese central and local governments are approaching their annual budgetary limits. By the end of June, while central and local governments have spent half of their budgeted expenditures for 2019, local governments had reached 70% of their total debt limits for the year. If the Chinese government is to stick to its 2019 budget, the fiscal impulse will lose steam in the second half of 2019: fiscal policy will actually tighten through the remainder of the year. Chart 10A and 10B illustrate that under such scenario, both fiscal spending and local government bond issuance will be trending down.  Chart 10AFiscal Impulse Losing Steam In 2H? Increasing spending by raising the budgeted deficit target ceiling is an option, though the least likely one. The basis is that a mid-year budgetary deficit revision would need the National People’s Congress’ approval, which has not occurred in the past 30 years.9  Nonetheless, the tone from the latest policy announcements suggests that the Chinese leadership is increasingly willing to work around these constraints and is positioning for a further loosening of fiscal spending. Chart 11Additional Funds Could Help, A Lot On June 11th, the Ministry of Finance made a policy announcement, relaxing financing restrictions on local government infrastructure spending. Local governments can now use proceeds from special-purpose bonds as capital to finance new spending on infrastructure projects.10 The new policy only applies to non-land development related infrastructure projects, which can make a maximum of 800 billion yuan available for infrastructure investment.11 As Chart 11 shows, if all of the additional 800 billion yuan is invested, a simple calculation suggests that it could lift infrastructure spending by as much as 4 percentage point before year end.  The government is also preparing for another round of local government off-balance-sheet debt swaps. The plan, which is still being formulated by the authorities, is to allow financial institutions to either extend or swap maturing local government off-balance-sheet debt with bank loans that carry lower interest rates and longer maturities. There are strict criteria as to what debt qualifies to be swapped. But with an estimated 30-40 trillion yuan of local government implicit debt, the size of this program could potentially be comparable to that of 2015-2016.12 But if the Chinese government were to allow the program to morph into a meaningful stimulus effort, it would require concerted effort from the central bank to equip commercial banks with the required liquidity. This would mean a further loosening in monetary conditions. Bottom Line: There are “soft constraints” hindering China from broadening its scope of fiscal spending for the year. For investors to feel confident that the policy response will lead to a meaningful re-acceleration in economic activity, these constraints will have to be overcome. Investment Implications As we pointed out in our previous China Investment Strategy Weekly,13 even with June’s large number in bank lending and total local government bond issuance, the cumulative progress in credit growth for the first half of the year is still closer to 27% of nominal GDP (assuming 8% nominal GDP growth for the remainder of 2019). This still falls into our “half-strength” credit cycle scenario relative to past reflationary episodes (Chart 12A & 12B).  Our bias is that the Chinese leadership will only allow limited additional stimulus this year, and are likely to wait until the economy weakens further before removing all budgetary and regulatory constraints. This will put the economy and financial market on a “W-shaped” trajectory for the rest of 2019. Therefore we recommend an underweight position in Chinese stocks for the remainder of the year. Ultimately, though, policymakers will respond if the economy weakens meaningfully further. The odds are good that the economy will have weakened enough for the Chinese government to make a concerted effort to fuel its economy over the coming 6-12 months. Thus, an overweight on Chinese stocks over a cyclical horizon is warranted, but the journey to eventual outperformance will be a turbulent one.   Jing Sima China Strategist JingS@bcaresearch.com     Footnotes: 1      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 3      In 2015, nominal GDP growth bottomed 5 months following a pickup in credit growth. 4      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “The Chinese Auto Market: Moderate Recovery Ahead”, dated February 13, 2019, available at cis.bcaresearch.com. 5      Pledged supplementary lending (PSL) scheme refers to China’s central bank’s direct lending to the real estate market. 6      The People’s Bank of China (PBoC) released RMB 698 billion in 2015 and RMB 971 billion in 2016 in the form of PSL injections into the real estate market as part of its attempts to revive the property market. 7      Including both general and special-purpose bonds, but discounting bonds issued for debt-to-bond swap or refinancing purposes. 8      Ministry of Finance Mid-Year Budgetary Press Conference, July 15, 2019 9      The last time the Chinese government issued a mid-year budget revision was following the Tiananmen Square Massacre, the only year China had a classical business cycle. It did NOT revise the budget during the 2008-‘09 global financial crisis, though. 10     Special-purpose bonds must be used for projects that are proven to make certain returns on investment and are supposed to be repaid with returns from the specific projects they are invest in, rather than fiscal revenue. Previously, local governments were prohibited from using borrowed money as capital in infrastructure projects. http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201906/t20190610_3274511.htm 11     The non-land development portion accounts for about 30% of total special-purpose bonds. 12     Some estimates suggest about 3-4 trillion yuan of local government implicit debt is qualified for the new swap program. 13     Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1 The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4 Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S. Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel). The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production. Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth. Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). 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 14 (PETER)The Dollar Is A Countercyclical Currency 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. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6 Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade. Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1 To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5 France is a good proxy for the euro area. 6 Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. Strategy & Market Trends* MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades