Europe

Highlights The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. Feature There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.1 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”2 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”3 Chart 1Imperial Overstretch Imperial Overstretch Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.4 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart 1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart 2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart 2China’s Mean Reverting Narrative Back To The Nineteenth Century Back To The Nineteenth Century In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart 3). Chart 3The Beijing Consensus Back To The Nineteenth Century Back To The Nineteenth Century Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead to Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. The U.S.-China conflict will not lead to complete bifurcation of the global economy. Diagram 1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram 1Trade War In A Bipolar World Back To The Nineteenth Century Back To The Nineteenth Century However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.5 The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.6 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart 4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart 4The World Is No Longer Bipolar The World Is No Longer Bipolar The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart 5). This is for three reasons: Chart 5Multipolarity Is Messy Multipolarity Is Messy Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.7 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. In a multipolar world, the U.S. will not be able to exclude China from the global system. Diagram 2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram 2Trade War In A Multipolar World Back To The Nineteenth Century Back To The Nineteenth Century Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.8 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts 1 and 4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”9 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”10 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”11 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.12 History teaches us that trade occurs even amongst rivals and during wartime. Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.13 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart 6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart 7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart 6The Allies Traded With Germany… Back To The Nineteenth Century Back To The Nineteenth Century Chart 7… Right Up To WWI Back To The Nineteenth Century Back To The Nineteenth Century Chart 8Japan And U.S. Never Downshifted Trade Back To The Nineteenth Century Back To The Nineteenth Century A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart 8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram 2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart 9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart 9The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart 10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart 11). Chart 10Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Chart 11Is Europe Really This Incompetent? Is Europe Really This Incompetent? Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing.   Marko Papic, Consulting Editor, BCA Research Chief Strategist, Clocktower Group Marko@clocktowergroup.com Footnotes 1 Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 2 Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 3 See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017). 4 The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 5 Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 6 We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own. 7 See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 8 Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 9 See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 10 Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 11 Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 12 Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia. 13 See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.

Highlights The slowdown in the U.S. manufacturing sector is at risk of becoming deeper than elsewhere. This is not bearish for the U.S. dollar, given that it is a countercyclical currency, but it is not a constructive development, either. This impasse can be solved by an easier Federal Reserve, which would knock down the dollar. For now, we are maintaining our trade focus on the crosses rather than on outright dollar bets. The Swiss National Bank is likely to start weaponizing its currency, given the domestic slowdown: Go long EUR/CHF at 1.06. Long yen positions have become a consensus trade, but we will await a better exit point for our short USD/JPY positions. Feature The Swiss economy is slowly stepping into deflation. The latest inflation print this week stood at 0.1%, well below the SNB’s central forecast of 0.4% for this year. Goods inflation has completely ground to a halt, while service inflation is now at the lowest level since 2016. If left unchecked, this could begin to un-anchor inflation expectations, leading to a negative feedback loop that the SNB will likely find very difficult to lean against (Chart I-1). Chart I-1The SNB Will Have To Lean ##br##Against This The SNB Will Have To Lean Against This The SNB Will Have To Lean Against This Chart I-2A Strong Franc Is Exerting A Powerful Deflationary Impulse A Strong Franc Is Exerting A Powerful Deflationary Impulse A Strong Franc Is Exerting A Powerful Deflationary Impulse Global disinflationary trends are definitely playing a role, but the strong currency has been front and center at exacerbating these trends. As a small, open economy, tradeable goods prices are important for Switzerland. Import prices are deflating by over 3% year-on-year, in part driven by a strong trade-weighted currency (Chart I-2). This is increasing the odds that the SNB will begin to use the currency to stimulate monetary conditions. Operation Weak Franc Chart I-3How Long Can You Defy The Pull Of Gravity? How Long Can You Defy The Pull Of Gravity? How Long Can You Defy The Pull Of Gravity? Domestically, the Swiss economy is holding up well, but it is an open question as to how much longer it will continue to defy the pull of a slowing external sector. The KOF employment indicator is at its highest level since 2010, and the expectations component continues to exceed the current assessment. During normal times, this is a bullish development. However, for a highly export-driven economy, the manufacturing sector usually dictates trends in the overall economy (Chart I-3). The manufacturing PMI print is currently sitting at 44.6, the worst since the financial crisis. These levels have usually rung loud alarm bells along SNB corridors. Back in 2011, Switzerland was rapidly stepping back into deflation, having just barely escaped it a year earlier. The SNB quickly realized that for a small, open economy, the exchange rate often dictates the trend in domestic inflation. Ergo, sitting and watching the trade-weighted Swiss franc continue to appreciate, especially given the euro was in a cascading downdraft, appeared to be a recipe for disaster. This sounds eerily similar to today. With the European Central Bank resuming quantitative easing and with an SNB that left rates unchanged at its most recent policy meeting, the signal is that interest rates have probably hit a floor. This view is further reinforced by the SNB’s additional tiering of reserves. In other words, rates have probably begun to teeter on the edge of financial stability. This leaves the currency as the policy tool of choice. Our bias is that the whisper floor of 1.08-1.10 for EUR/CHF will continue to persist until the Swiss economy decisively exits deflation. However, markets can tilt the Swiss exchange rate to an overshoot. If that happens, four key factors suggest the Swiss economy needs a weaker currency, especially versus the euro: The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade. The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade (Chart I-4). However, in a downturn, while commoditized goods prices are the first shoe to drop, the slowdown eventually starts to infect more specialized goods prices. Swiss goods are not easily substitutable, but other countries such as Sweden that have dropped their currency will benefit more from any recovery. Chart I-4Rising Terms Of Trade Have Helped ##br##Support Exports Rising Terms Of Trade Have Helped Support Exports Rising Terms Of Trade Have Helped Support Exports Chart I-5A Gold ##br##Haven A Gold Haven A Gold Haven Part of the improvement in the Swiss trade balance has been driven by precious metals exports. For example, exports of precious metals to the U.K. are soaring towards new highs as storage demand for ETF accounts rises (Chart I-5). However, there has been a lack of physical demand in Asia, while the riots in Hong Kong are causing gold to be rerouted to Switzerland, then London. This might soon end. Our models suggest the franc is now almost 10% overvalued versus the euro. Over the history of the model, franc overvaluation peaks at a high of 15%, and is often followed by intervention by the SNB (Chart I-6). While the unemployment rate is at 2.3%, domestic wage pressures are none existent. It will be difficult for service inflation to pick up without a build-up in wage pressures. This is unlikely to happen over the next six to nine months. Part-time employment continues to dominate job gains, meaning the need for precautionary savings will continue to restrain spending. Meanwhile, the manufacturing sector is unlikely to start raising wages before a recovery is in sight. However, more recently, foreign exchange reserves have started reaccelerating and the stability in the monetary base suggests some spectre of sterilization. It has been surprising that in the global race towards lower rates and amidst the potential for global currency devaluation, the SNB has been sitting and watching other central banks like the ECB and the Riksbank eat part of its lunch. The message from SNB Central Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market if necessary. This might slightly suggest disagreement within the governing council. Chart I-6The Franc Is ##br##Expensive The Franc Is Expensive The Franc Is Expensive Chart I-7Is The SNB Sterilizing Reserve Accumulation? Is The SNB Sterilizing Reserve Accumulation? Is The SNB Sterilizing Reserve Accumulation?   Interestingly, the SNB has not had to ramp up its balance sheet significantly in recent years. Part of the reason is that the slowdown in global trade eased natural demand for francs, which meant the SNB was no longer accumulating foreign exchange reserves at a rampant pace. This has helped drain excess liquidity from the system and somewhat renormalize policy. This means that the wiggle room for more FX intervention has reopened. However, more recently, foreign exchange reserves have started reaccelerating, and the stability in the monetary base suggests some spectre of sterilization (Chart I-7). Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G-10. Too little stimulus and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations continue to be anchored strongly to the downside. Too much stimulus, and the result will be a build-up of imbalances, leading to an eventual bust. Currency Cap Post-Mortem While the SNB may favor stealth depreciation of the franc, there are both political and economic constraints to an outright cap. The good news is that the economic forces are ebbing as the economy slows down. Meanwhile, there had already been a rising chorus of discontent among right-wing politicians in 2014, specifically those within the Swiss People’s Party (SVP) who wanted the central bank to stop buying foreign currencies and significantly lift its gold holdings instead. With the SVP currently ahead in opinion polls ahead of this month’s elections, this is likely to remain a constraint. The good news is that new issues such as climate change have taken the fore, rather than whether Switzerland should start backing it reserves via gold (Chart I-8). The key risk to a cap is that if the euro drops substantially, it will invite speculation back into the Swiss economy. This risk is clearly unpalatable for both Swiss politicians and the SNB, which is why two-way asymmetry was reintroduced into the system in 2015. Chart I-8The Swiss People's Party Will ##br##Like This Up! The Swiss People's Party Will Like This Up! The Swiss People's Party Will Like This Up! Chart I-9A Healthy ##br##Rebalancing A Healthy Rebalancing A Healthy Rebalancing On a positive note, housing market speculation has been somewhat cleansed. Growth in rental housing units, which usually constitutes the bulk of investment homes, has grown to a standstill, and this is positively deviating from growth in owner-occupied homes. The message from this is clear: Macro-prudential measures such as a cap on second homes as well as stricter lending standards have helped (Chart I-9). Back in 2015, the SNB smartly surprised the market by abandoning the EUR/CHF floor. This helped rebalance the market as European investors who used the SNB put to speculate on properties in Zurich and Geneva were dis-incentivized once the euro collapsed. Demand for Swiss real estate has largely stabilized since then, eliminating this key source of risk for the SNB. The SVP’s curb on immigration has neutered a meaningful source of demand. Vacancy rates for rental properties have started to inflect meaningfully higher. More importantly, vacancy rates for rental properties have started to inflect meaningfully higher. This has usually led to lower housing prices, with a lag of about 12 months (Chart I-10). With the SVP unlikely to become more pro-immigration anytime soon, this will likely remain a headwind (Chart I-11). This suggests the political capital for the SNB to use stealth depreciation of the currency to stimulate the economy is high, especially as the global economy remains mired in a manufacturing downturn. A history of budget surpluses suggests that the SVP is unlikely to pass any significant pro-fiscal policies at any time soon. Chart I-10Slowing Migration Is Curbing Housing Demand Slowing Migration Is Curbing Housing Demand Slowing Migration Is Curbing Housing Demand Chart I-11A Slowing Workforce Is Curbing Housing Demand A Slowing Workforce Is Curbing Housing Demand A Slowing Workforce Is Curbing Housing Demand Claims on bank balance sheets from foreigners are relatively low, meaning the risk from an inflow of capital into the housing market on a lower exchange rate is low (Chart I-12). With bank lending margins likely to be depressed for the next few years, some foreign inflows into the real estate sector would help, alongside stricter macro prudential measures. Chart I-12Banks Have Low Foreign Mortgage Liabilities Banks Have Low Foreign Mortgage Liabilities Banks Have Low Foreign Mortgage Liabilities On EUR/CHF And USD/CHF Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of 115% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion (Chart I-13). Meanwhile, hedging costs for short CHF trades are less attractive than a year ago. They might get more prohibitive but until then, we suggest prudence in going short the franc versus the euro or USD (Chart I-14). Our bias however, is that the SNB will significantly start to lean against the franc at 1.06. Chart I-13Risk: Swiss Franc Tends ##br##To Appreciate Risk: Swiss Franc Tends To Appreciate Risk: Swiss Franc Tends To Appreciate Chart I-14Hedging Costs Are ##br##Prohibitive Hedging Costs Are Prohibitive Hedging Costs Are Prohibitive   Investment Conclusions Chart I-15Major Dollar Tailwinds Have Peaked Major Dollar Tailwinds Have Peaked Major Dollar Tailwinds Have Peaked We continue to focus on trades at the crosses, and holding portfolio insurance such as the Swiss franc remains what the doctor ordered. Our objective in this week’s report was to highlight that investors and traders may not want to overstay their welcome, and as such keep a watchful eye on tentative signs of a reversal. Typically, the growth divergence between the U.S. and the rest of the world has been a good explanatory variable for medium-term fluctuations in the dollar. Ergo, the deceleration in the U.S. manufacturing PMI usually foretells a bad omen for the dollar (Chart I-15). The franc tends to do well at the crosses during dollar bull markets and poorly during dollar bear markets. However, there are benign adjustments and malignant ones, and a drop in the U.S. manufacturing PMI, driven by much slower global growth, looks like the malignant type. What we will need to see, if the weak dollar narrative is to pan out, is stabilization in the U.S. manufacturing sector, as the rest of the world’s manufacturing sector inflects higher. This will also weaken the franc at the crosses. Stay tuned.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 There was a flurry of U.S. data releases, the balance of which was negative: Headline PCE was unchanged at 1.4% year-on-year in August. Core PCE increased to 1.8% year-on-year. Chicago purchasing managers’ index fell to 47.1 in September from 50.4 in August. Dallas Fed manufacturing business index fell to 1.5 in September from 2.7 in August. ISM manufacturing PMI plunged to 47.8 in September, the second consecutive month below 50. Moreover, ISM non-manufacturing PMI fell to 52.6 in September from 56.4, well below expectations of 55. Admittedly, the Markit composite PMI was up at 51 versus 50.7 the prior month. ADP non-farm payrolls were below expectations at 135K in September, versus 157K in August. Durable goods orders monthly growth slowed to 0.2% in August. Factory orders contracted by 0.1% month-on-month in August. DXY index rose by 0.6% initially, then plunged, losing 0.4% this week. The deterioration in both ISM manufacturing and non-manufacturing PMIs spurred worry about an imminent recession. We get the jobs report this Friday, which is one of the last pillars of support for a relatively hawkish Fed policy. On the monetary policy front, the Fed will resume the balance sheet expansion. The increase in supply of dollars will add to the forces that might eventually pull the dollar lower. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: Inflation remains subdued across euro area countries in August. Headline inflation in the euro area fell to 0.9% year-on-year from 1%. In France, the headline inflation declined to 1.1% year-on-year from 1.3%. In Spain, it fell to 0.1% year-on-year from 0.3%. In Germany, it also decreased to 1.2% year-on-year from 1.4%. The unemployment rate in the euro area marginally decreased to 7.4% in August from 7.5%. The economic sentiment indicator in the euro area fell to 101.7 in September from 103.1. Producer price index fell by 0.8% year-on-year in August. Retail sales growth was little changed at 2.1% year-on-year in August. EUR/USD increased by 0.6% this week. On the inflation front, the steeper drop in CPI for core countries rather than the peripheral ones suggests that the redistributive efforts needed to hold the euro area together are somewhat working. ECB president Mario Draghi called for an “investment-led stimulus at the euro area level” in a speech in Athens on Tuesday evening, but the reality is that the peripheral countries are already using lower rates to deploy capital. J.P. Morgan analysts have upgraded European equities this week. If equity fund flows start to rise, the euro is likely to rebound against the U.S. dollar. Report Links: A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been disappointing: The all-important Tankan survey came out this week. There was deterioration in both the manufacturer and service outlook in Q3, but it was admittedly above expectations. Plans for capex remained relatively elevated. Industrial production contracted by 4.7% year-on-year in August. Retail sales increased by 2% year-on-year in August, but we are downplaying this because of the consumption tax hike. Housing starts decreased by 7.1% year-on-year in August. Construction orders fell by 25.9% year-on-year (the latter being extremely volatile). The unemployment rate was unchanged at 2.2% in August. Jobs-to-applicants ratio was also unchanged at 1.59. Consumer confidence fell to 35.6 in August, from 37.1 in July. We have discussed in length the significance of this in a Ricardian equivalence framework. Services PMI fell to 52.8 in September, while still above the 50 expansionary territory. USD/JPY fell by 1% this week. In the recent Summary of Opinions, the BoJ highlighted risks of lower external demand due to delayed economic growth. On the positive side, various countermeasures are set to mitigate the negative effects of the tax hike. We remain positive on the safe-haven Japanese yen as a hedge with limited downside. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mixed: GDP growth increased to 1.3% year-on-year in Q2. On a quarter-on-quarter basis however, GDP growth contracted by 0.2% in Q2. Current account deficit narrowed to £25.2 billion in Q2, from £33.1 billion in Q1. Nationwide house prices grew by 0.2% year-on-year in September, compared with 0.6% in August. Markit manufacturing PMI increased to 48.3 in September from 47.4; Construction PMI fell to 43.3 from 45; Services PMI fell below 50 to 49.5. GBP/USD increased by 0.8% this week. PM Boris Johnson gave a speech this week and introduced the details of a Brexit proposal that was an easy target for the firing squads in this imbroglio. Another Brexit delay and re-election seem highly likely. The improvement in the Markit manufacturing PMI reflects higher confidence over the lower probability of a hard Brexit in our view. We recently upgraded the outlook for U.K. and went long the GBP/JPY. Stay with it.  Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Headline inflation slowed from 1.7% to 1.5% year-on-year in September. Private sector credit grew by 2.9% year-on-year in August. AiG manufacturing PMI increased to 54.7 in September from 53.1 in August. AiG services PMI marginally increased to 51.5 from 51.4. Commonwealth manufacturing PMI fell slightly to 50.3, from an upward-adjusted 50.9 in August. Commonwealth services PMI was little changed at 52.4. Building permits keep contracting by 21.5% year-on-year in August. Exports fell by 3% month-on-month in August, while imports were unchanged. The trade surplus narrowed to A$5.9 billion from A$7.3 billion. AUD/USD fell by 1.3% initially post RBA, then recovered with broad U.S. dollar weakness, returning flat this week. The RBA lowered interest rates by another 25 basis points on Tuesday, and stated that “the Australian economy is at a gentle turning point.” Lower rates, though not fully transferred to mortgage rates, could help to stabilize the housing market to some extent, and lift wage growth. We maintain a pro-cyclical stance and remain positive on the Australian dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mostly negative: Building permits increased by 0.8% month-on-month in August. Activity outlook fell by 1.8% month-on-month in September. Business confidence fell further to -53.5 in September, from -52.3 in August. NZD/USD increased by 0.3% this week. The latest Quarterly Survey of Business Opinion, conducted by the New Zealand Institute of Economic Research, has shown that business conditions point to further slowing in economic activity. The manufacturing sector remains the most problematic. Moreover, firms are cautious about expanding, due to the combination of intense cost pressures, and weak pricing power. Australia has lowered interest rates giving ammunition to their antipodean neighbors to follow suit. The probability of rate cuts by RBNZ in its next policy meeting on November 13th reached 100%: 90% for a 25 bps cut and 10% for 50 bps. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mixed: On a month-on-month basis, the GDP stagnated in July. On a year-on-year basis, GDP growth slowed from 1.5% to 1.3% in July. Markit manufacturing PMI increased to 51 in September, from 49.1 in August. Bloomberg Nanos confidence increased to 57.8 for the week ended September 27th. Raw material prices fell by 1.8% month-on-month in August. USD/CAD increased by 0.5% this week. Canadian GDP growth in July was led by the services sector. The divergence was 2.5% year-on-year in July for services GDP, while goods GDP continued to deteriorate, contracting by 1.8% year-on-year. GDP in the energy sector, a focal industry in the country, fell by 3.4% year-on-year in July, affected by the fluctuations in oil prices. Moreover, as our colleagues in Commodity & Energy Strategy point out, the price differential between Canadian crude oil and WTI would likely to deepen further, possibly reaching a discount of $20/bbl into 1Q20, due to transportation constraints in the west. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 93.2 in September. Real retail sales contracted by 1.4% year-on-year in August. Manufacturing PMI fell to 44.6 in September from 47.2 in August. Headline inflation decreased to 0.1% year-on-year in September, from 0.3%. USD/CHF increased by 0.7% this week. While the Swiss economy is highly linked to global developments, especially those in the euro area, the positive current account balance makes it less vulnerable on a relative basis. We continue to favor the franc as a safe-haven hedge. We discuss the franc in this week’s front section. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There are scant data from Norway this week: Retail sales were unchanged in August. USD/NOK appreciated by 0.3% this week. The recent decline in oil prices has pushed our petrocurrency basket trade offside, weighed by the quick oil facility recovery in Saudi and demand concerns over a possible recession. That said, we continue to overweight energy prices and the Norwegian krone. The looming tension in the Middle East could lead to further escalation, which will again disrupt oil supplies and lift oil prices.  Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Retail sales grew by 2.7% year-on-year in August, compared to a 3.9% yearly growth in July. Manufacturing PMI plunged to 46.3 in September, from 52.4 in August. USD/SEK increased by 0.5% this week. While the PMI employment component increased to 52.4 from 51.9, the new orders index plunged below 50 to 45.8. The new orders-to-inventory ratio also continues to decrease, which usually leads the euro area manufacturing PMI by a few months. This is one of the key data points we follow, so are heeding to the message from this indicator. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights MARKET FORECASTS Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist   I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows     An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering   The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright   The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 10Who Will Win The 2020 Democratic Nomination? Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows China: No Major Capital Outflows China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1  The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20).   Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound U.S. Housing Will Rebound U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM chart 27 The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future.   Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive European Banks Are Attractive European Banks Are Attractive Chart 35Is Value Turning The Corner? Is Value Turning The Corner? Is Value Turning The Corner?   Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36).     Chart 36BYields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38).  Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 39Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit     Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Supply Deficit To Continue Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 48Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Tactical Trades Strategic Recommendations Closed Trades

Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Credit Growth To Rebound In The Fourth Quarter, Then Fade Credit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse The Euro Area Bond Yield Impulse Leads Its Credit Impulse The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse The U.S. Bond Yield Impulse Leads Its Credit Impulse The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse The China Bond Yield Impulse Leads Its Credit Impulse The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter.  A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter German Car Production Rebounded In The Third Quarter German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity Growth To Rebound In The Fourth Quarter, But Fade In 2020 Growth To Rebound In The Fourth Quarter, But Fade In 2020   The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1  Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth The Oil Price Impulse Explains Oscillations In German Growth The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter.  How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows:  Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Global Equities Have Gone Nowhere For Two Years Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China Stay Overweight Europe Versus China Stay Overweight Europe Versus China   Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Nickel VS. Gold Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming First Signs Of Bottoming First Signs Of Bottoming Chart 2Surprisingly Strong Surprises Surprisingly Strong Surprises Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low? Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Gold: Sell Or Hold? Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? How Low Can They Go? How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid U.S. Growth Remains Solid U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials Upgrade Global Financials Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers Favor Linkers Favor Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation