Europe

Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession A Eurozone Manufacturing Recession A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth The Euro Needs Stronger Growth The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish A Few Trade Ideas A Few Trade Ideas The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long.  The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Deflation Remains Predominant In The Eurozone Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Stocks And Currencies: An Unsustainable Divergence Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Higher Oil is Negative For EUR/NOK Higher Oil is Negative For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely A Tactical Bounce In GBP/JPY Is Likely A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound The Benefit Of A Weaker Pound The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed.  In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession.   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 Recent data in the U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. 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 continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July.  The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 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 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 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: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. 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 negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. 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 resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. 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 mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July.  Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading  partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. 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 is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 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: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. 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 President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol Impeachment Proceedings Likely To Raise Vol Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change Spanish Voter Is Not Demanding Change Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Not Much Change In Polls... Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Spaniards Love Europe Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room Spain Has Some Fiscal Room Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Recovery Starting To Slow Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention.   Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator U.K.: GEORISK INDICATOR U.K.: GEORISK INDICATOR France: GeoRisk Indicator FRANCE: GEORISK INDICATOR FRANCE: GEORISK INDICATOR Germany: GeoRisk Indicator GERMANY: GEORISK INDICATOR GERMANY: GEORISK INDICATOR Spain: GeoRisk Indicator SPAIN: GEORISK INDICATOR SPAIN: GEORISK INDICATOR Italy: GeoRisk Indicator ITALY: GEORISK INDICATOR ITALY: GEORISK INDICATOR Russia: GeoRisk Indicator RUSSIA: GEORISK INDICATOR RUSSIA: GEORISK INDICATOR Turkey: GeoRisk Indicator TURKEY: GEORISK INDICATOR TURKEY: GEORISK INDICATOR Brazil: GeoRisk Indicator BRAZIL: GEORISK INDICATOR BRAZIL: GEORISK INDICATOR Taiwan: GeoRisk Indicator TAIWAN: GEORISK INDICATOR TAIWAN: GEORISK INDICATOR Korea: GeoRisk Indicator KOREA: GEORISK INDICATOR KOREA: GEORISK INDICATOR What's On The Geopolitical Radar? Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Section III: Geopolitical Calendar

Highlights U.S. growth will soon rebound thanks to robust drivers of domestic activity, and strengthening money and credit trends. The U.S. Federal Reserve will maintain an easing bias and will expand its balance sheet again. A growing Fed balance sheet will catalyze an underlying improvement in global liquidity conditions and boost the global economy. Brexit, China and Iran are key risks. The dollar will depreciate, bond yields will rise further and silver will outperform gold. Equities will surpass bonds on both cyclical and structural investment horizons. Financials and energy are more attractive than tech and healthcare. Thus, Europe is becoming increasingly appealing relative to the U.S. Feature Global equities are only 5% below their January 2018 all-time highs and the S&P 500 is close to breaking out above its July 2019 record. Meanwhile, yields are rebounding and value stocks are crushing momentum plays. Are these trends durable? Global growth is the key. If economic activity around the world can stabilize and ultimately improve, then stocks will break out and bond prices will suffer in the coming year. Otherwise, these recent financial market developments will undo themselves. Even if current activity remains weak, the outlook for global growth is looking up, despite trade wars, Brexit, Middle East tensions and problems in the interbank market. Therefore, we continue to favor stocks over bonds, because the backup in yields has further to go. If the dollar weakens, our pro-risk stance will only strengthen. U.S. Growth Drivers Are Healthy Chart I-1Recession Indicators Are Flashing A Yellow Flag Recession Indicators Are Flashing A Yellow Flag Recession Indicators Are Flashing A Yellow Flag The U.S. is near the end of a potent mid-cycle slowdown, but a recession will be avoided. Current conditions support an improvement in U.S. activity next year, even if key recessionary indicators, such as the yield curve and the annual rate of change of the Leading Economic Indicator, are still sending muddy signals (Chart I-1). U.S. growth will intensify because of five fundamental factors that will ultimately push the LEI higher and force the yield curve to re-steepen: A budding housing rebound, robust household spending, a stabilizing manufacturing sector, limited inflationary pressures, and a pick-up in money and credit trends. Housing The housing market has stabilized, buoyed by strong household formation, decent affordability, passing of the shock created by the cap in state and local tax deductions, and a 110-basis point collapse in mortgage yields since November 2018. Housing market indicators are finally catching up with leading variables, such as mortgage applications. In the past nine months, the NAHB housing market index has recovered nearly two-thirds of its decline since December 2018. Building permits and housing starts are at their highest levels since 2007, despite a significant fall last year. Even existing home sales have increased by 11% since December and are tracking the stimulation offered by lower borrowing costs (Chart I-2). Chart I-2The Housing Recovery Is Real The Housing Recovery Is Real The Housing Recovery Is Real Residential investment should soon boost economic activity after curtailing the level of GDP by 1% over the past six quarters. Moreover, rebounding housing activity implies that policy is not constraining growth. The real estate sector is historically the most sensitive to monetary conditions. Households Are Still Doing Well Core U.S. real retail sales continue to grow at a more than 4% annual pace and the Atlanta Fed GDPNow model forecasts a healthy 3.1% annual rise in consumer spending in the third quarter. This resilience is particularly impressive in the face of economic uncertainty and an ISM Manufacturing index below the 50 boom-bust line. Strong balance sheets are crucial to households. After 12-years of deleveraging, household debt has contracted by 37 percentage points to 99% of disposable income. Consequently, debt-servicing costs only represent 10% of disposable income, the lowest level in more than 45 years. Moreover, the household savings rate is a healthy 7.9% of after-tax income, which is particularly high in the context of the highest net worth ever and the lowest debt-to-asset ratio since 1985. Household income creates an additional support to consumption. Real disposable income is expanding at a 3% annual rate, despite slowing job creation. A tight labor market explains this apparent paradox. The employment-to-population ratio for prime-age workers is our favorite measure of labor market slack, and it has escalated to 79.7%, a level consistent with the 2.9% pace of annual growth in wages and salary (Chart I-3). The UAW strike at GM, the quits-rate at an 18-year high, and the difficulties small firms face to find qualified workers, all suggest that wages (and thus, consumption) will remain well underpinned (Chart I-3, bottom panel). Improving Manufacturing Outlook Manufacturing activity is set to rebound, despite the weakness in the ISM Manufacturing index. Recent industrial production numbers have already improved. Monthly IP expanded at a 0.6% monthly pace in August, but as recently as April, it was shrinking at a -0.6% rate. U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The car sector will soon bottom. Weak auto production has been a primary diver of the recent global manufacturing slowdown. The automotive component of GDP contracted at a stunning 29.1% annual rate in the second quarter. However, U.S. light-vehicle sales are essentially flat. This dichotomy implies that the automobile sector’s inventories are contracting briskly (Chart I-4). Chart I-3A Tight Labor Market Supports Consumption October 2019 October 2019 Chart I-4Will Auto Production Rebound Soon? Will Auto Production Rebound Soon? Will Auto Production Rebound Soon?   Capex should also recover. Last quarter, investment in structures and equipment subtracted from GDP growth. Before this, capex intentions had fallen significantly, now, the Philly Fed’s capital expenditure component is trying to stabilize. Capex must stop falling if global manufacturing is to strengthen. Limited Inflationary Pressures Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued expansion. Secondly, low inflation keeps real income growth higher and increases the welfare of households. At 2.4%, core CPI is perky, but will soon roll over. Core goods prices have been driving fluctuations in aggregate core prices in the past three years, while service sector inflation has been stable at 2.7% during this period. Goods inflation will soon weaken for the following reasons: Chart I-5The Trade War Is Masking The Economy's Deflationary Tendencies The Trade War Is Masking The Economy's Deflationary Tendencies The Trade War Is Masking The Economy's Deflationary Tendencies Soft global economic activity will drive down global inflation. Inflation lags real activity and proxies for the global economy, such as Singapore’s GDP, point to weaker core CPI in the OECD (Chart I-5). This weakness will act as a drag on U.S. inflation because U.S. goods prices have a large international component. U.S. import prices peaked 15 months ago and they normally lead goods inflation by roughly a year and a half. The strength in the broad trade-weighted dollar, which has climbed by nearly 15% in the past 18 months to an all-time high, will hurt goods prices. U.S. capacity utilization declined through 2019 and remains well below the 80% level that historically causes core goods prices to overheat. The White House’s tariffs on China are boosting inflation but this effect will prove transitory. The tariffs are pushing up inflation for goods touched by the levies, while unaffected goods are experiencing deflation (Chart I-5, bottom panel). Given that tariffs have a one-off impact and that inflation expectations are hovering near record lows, inflation for tariffed-goods will converge toward the underlying trend in non-tariffed goods. Stronger Money And Credit Trends Money and credit trends indicate that the recent slump will not translate into a recession. Moreover, improving U.S. private-sector liquidity conditions argues that the mid-cycle slowdown is ending. Chart I-6Liquidity Indicators Point To A Growth Rebound Liquidity Indicators Point To A Growth Rebound Liquidity Indicators Point To A Growth Rebound U.S. broad money is recovering. After falling to 0.9% last November, U.S. real M2 growth is expanding at a 3% annual rate, a pace in keeping with the end of mid-cycle slowdowns. Moreover, money is also accelerating relative to credit issuance, which historically has pointed to quicker industrial activity. Similarly, our U.S. financial liquidity index is rapidly escalating, a development that normally precedes turning points in the ISM manufacturing (Chart I-6) index. Credit activity is also picking up. Corporate bond issuance is firming and, according to the Fed’s Senior Loan Officer Survey, demand for loans is rebounding across the board. The yield collapse is boosting credit growth across the G-10. Gold is outperforming bonds, which confirms that a mid-cycle slowdown occurred. If inflation is not a problem, then the yellow metal always underperforms bonds ahead of recessions. However, before mid-cycle slumps, gold consistently outperforms bonds (Chart I-7). Chart I-7Bonds Outperform Gold Ahead Of Recession Bonds Outperform Gold Ahead Of Recession Bonds Outperform Gold Ahead Of Recession More Fed Easing Imminent U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The Fed will ease policy further and is a long way from tightening. Last week, the Federal Open Market Committee (FOMC) curtailed the fed funds target rate by 25 basis points to 2%. Additionally, while the median projection shows that Fed members expect no more rate cuts for at least the next 18 months, the reality is more subtle. Among 17 FOMC members, 7 expect to cut the fed funds rate by another 25 basis points by year end, and 8 foresee a lower policy rate in late 2020. The greenback is very expensive and will decline as global liquidity conditions improve. We are still on track for three 25-basis-point rate cuts this year. The Fed remains highly data dependent and is particularly sensitive to depressed inflation expectations. This means the Fed is acutely aware of the danger created by a sudden tightening in financial conditions. If by year-end the market has not moved away from discounting another cut in 2019, the FOMC will likely deliver this easing. Otherwise, financial conditions could suddenly tighten, which would hurt inflation expectations and the economic outlook. If global growth does not recover in early 2020, the Fed would probably cut rates an additional time in the first quarter, which would validate the current 12-month pricing in the OIS curve. Chart I-8Not Enough Excess Reserves Not Enough Excess Reserves Not Enough Excess Reserves The Fed will again increase the size of its balance sheet. Interbank markets have boxed the FOMC into adding welcomed stimulus to the global economy. Allowing commercial bank excess reserves to grow anew will have a greater positive impact for global growth compared with rate cuts alone. Last month, we highlighted the risks to the repo market created by the combination of the dwindling of excess reserves, the bloated securities inventory of primary dealers financed via repo transactions, and the growth in the issuance of Treasurys.1 These risks materialized last week, when the Secured Overnight Financing Rate (SOFR) suddenly spiked above 5% (Chart I-8). To calm the market, the Fed injected $75 billion each day last week starting Tuesday to bring repo rates closer to the Interest Rate on Excess Reserves (IOER). But this is not a long-term solution. Chart I-9Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Paradoxically, the crystallization of the repo market tensions is good news for the global economy because it will force the Fed to again expand its balance sheet as soon as next month. The supply of funds to the repo market needs to increase permanently, which means that banks’ excess reserves must re-expand. As we showed last month, higher excess reserves will hurt the U.S. dollar, lift EM exchange rates and boost global PMIs (Chart I-9). Higher excess reserves ease global liquidity conditions. The money injected will find its way to the rest of the world. The dollar trades 25% above its long-term, fair-value estimate of purchasing power parity. Therefore, a growing fiscal deficit indirectly financed by a larger Fed balance sheet will lead to a larger U.S. current account deficit, which in turn, will lift global FX reserves. As a result, the Fed’s custodial holdings of securities on behalf of other central banks will rise. Thus, global dollar-based liquidity will stop contracting relative to the stock of U.S. dollar-denominated foreign currency debt it supports (Chart I-10). Higher excess reserves will also ease global financial conditions. By boosting dollar-based liquidity, a larger Fed balance sheet will dampen offshore dollar interest rates. Moreover, rising excess reserves depreciate the greenback, which further cuts the cost of credit for foreign entities borrowing in U.S. dollars. This phenomenon is especially significant for EM. Therefore, we should see an easing of EM financial conditions, which are heavily dependent on EM exchange rates. Historically, looser EM financial conditions lead to stronger global growth (Chart I-11). Chart I-10High-Powered Liquidity Set To Improve High-Powered Liquidity Set To Improve High-Powered Liquidity Set To Improve Chart I-11Easier EM FCI Should Lead To Faster Growth Easier EM FCI Should Lead To Faster Growth Easier EM FCI Should Lead To Faster Growth   Risks: The U.K., China And Iran While the outlook generally points to a rebound in global growth, which will create a positive environment for risk assets, the situations in the U.K., China, and Iran should be closely monitored. The U.K. Brexit remains a potential danger for the world even though our base case calls for a benign outcome. U.K. Prime Minister Boris Johnson’s gambit to push for a No-Deal Brexit to force the EU to make concessions could result in a miscalculation. Such a turn of events would plunge a European economy – already damaged by weak global trade – into recession. The dollar would strengthen and global financial conditions would tighten. Global growth would take another hit. Chart I-12U.K.: No Clear Winner Ahead Of A Potential Election U.K.: No Clear Winner Ahead Of A Potential Election U.K.: No Clear Winner Ahead Of A Potential Election Following this week’s Supreme Court unanimous ruling against Johnson’s decision to prorogue Parliament, No-Deal carries a less than 10% probability. Johnson lacks a majority in a Parliament staunchly against a hard Brexit and he is unable to call an election prior to the October 31st deadline to leave the EU. Therefore, a delay is the most likely outcome, which will allow the EU and the U.K. to reach a deal on the Irish backstop that Parliament can then ratify. Ultimately, the U.K. needs another election to break the current logjam, which could materialize in November or December. However, the Remain vote is split between Labour, Lib Dems, and the SNP, but the Brexit vote is not nearly as divided. (Chart I-12). Hence, Brexit will remain a risk lurking in the background even if it does not morph into a full-blown assault on global growth. China Chart I-13Chinese Stimulus Remains Too Tepid To Move The Needle Chinese Stimulus Remains Too Tepid To Move The Needle Chinese Stimulus Remains Too Tepid To Move The Needle China’s economic activity continues to soften. In August, industrial production and fixed-asset investment decelerated to 4.4% and 5.5%, respectively. Moreover, total social financing growth slowed on an annual basis and overall Chinese credit flows decreased as a share of GDP (Chart I-13). Chinese policy reflation remains too tepid to undo the drag created by trade uncertainty and the weakness in the marginal propensity to spend (Chart I-13, bottom panel). Sino-U.S. trade tensions have significantly decreased in recent months, but they will remain an important source of uncertainty for China and the world. China and the U.S. will again hold high-level talks next month, U.S. President Donald Trump has again postponed some of the tariff increases, and China is again buying mid-Western soybeans and pork. But last Friday’s cancelation of U.S. farm visits by Chinese officials reminds us that the situation is very fluid. Ultimately, China and the U.S. are long-term geopolitical rivals. Trump may be constrained by the 2020 election, but China could still drive a hard bargain. Hence, it is prudent to expect a stop-and-go pattern in the negotiations. Chart I-14Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs A weak China will sow the seeds of its own recovery. In addition to the negative effect on capex intentions and credit demand of trade uncertainty, Beijing faces deteriorating employment and producer price inflation of -0.8% (Chart I-14, top panel). As PPI inflation becomes more negative, heavily indebted corporate borrowers face rising real interest rates (Chart I-14, bottom panel). This higher cost of debt weakens an already vulnerable economy, unleashing a vicious circle. Chinese policymakers are unlikely to tolerate this situation for much longer. The cumulative 400-basis point cuts in the reserve requirement ratio since April 2018 are steps in the right direction, but are not yet enough. The dovish change to the Politburo’s and State Council’s language indicates that greater stimulus is forthcoming. Thus, credit expansion, local government special bonds issuance and fiscal stimulus will become even more prevalent in the final quarter of 2019. This policy should noticeably goose economic activity in 2020, which will help global growth accelerate. Iran Tensions are re-flaring and a spike in oil prices would threaten the fragile global economy. However, this remains a risk, not a central case. In the July issue of The Bank Credit Analyst, we warned that tensions with Iran were the greatest visible risk to global growth and risk assets.2 This danger came into focus last week with the drone attacks on the Khurais oil field and Abqaiq oil processing facility in Saudi Arabia, which curtailed global oil supply by an unprecedented 5.7 million bbl/day, or 5.5% of global demand. Unsurprisingly, Brent prices quickly surged by 12% to $68/bbl. Chart I-15Higher Energy Efficiency Makes The World More Robust Higher Energy Efficiency Makes The World More Robust Higher Energy Efficiency Makes The World More Robust A durable spike in oil prices would push the global economy into a recession, especially while the global economy is already on weak footing. Chief U.S. Equity Strategist Anastasios Avgeriou reminded his clients3 that according to a seminal 2011 paper by Prof. James D. Hamilton, a doubling of oil prices preceded all but one of the post-war recessions.4 However, an oil-induced recession would likely be shallow because the oil intensity of the global economy has significantly declined in the past 30 years (Chart I-15). Moreover, global fiscal authorities would respond forcefully to an economic contraction, which would also limit the impact of the shock. There is a low likelihood that oil will double by year-end. It would require Brent prices to surge to $100/bbl. Saudi Arabia has already stated that production will return to pre-crisis levels in the coming days and not a single shipment will be missed. This promise implies further inventory drawdowns. Aramco also expects to achieve maximum output by late November. Moreover, higher oil prices will encourage further activity in the U.S. shale patch. Consequently, oil prices are unlikely to surge by another $35/bbl in the next three months. However, Brent prices could climb to $75/bbl next year, because while oil demand is set to recover, investors must also embed a greater risk premium against Saudi supply disruptions. A military conflict with Iran is a tail risk, but if it were to materialize, crude prices would surge by $35/bbl or more in an instant. According to Matt Gertken, BCA’s Chief Geopolitical strategist, the appetite for such a conflict is low in the U.S.5 President Trump has isolationist instincts and does not want to be mired in another conflict. Investment Implications The Dollar The dollar has significant downside. The greenback is very expensive and will decline as global liquidity conditions improve (Chart I-16). These dynamics reflect the countercyclical nature of the dollar and also lead to strong greenback momentum, both on the way up and down. The dollar would weaken in response to improving global growth and liquidity conditions, the lower dollar would ease global financial conditions, further stimulating the global economy. A virtuous circle could then emerge. Chart I-16Increasing Financial Liquidity Will Hurt The Greenback Increasing Financial Liquidity Will Hurt The Greenback Increasing Financial Liquidity Will Hurt The Greenback Repatriation flows will also move from a tailwind to a headwind for the greenback. Prompted by both rising risk aversion and the Trump tax cuts, U.S. economic agents have repatriated $461 billion in the past 18 months. This has created powerful support for the USD (Chart I-17). The effect of the tax cut is vanishing and rising global growth will incentivize U.S. households and firms to buy foreign assets more levered to the global business cycle. In the process, they will sell the dollar. Chart I-17Repatriation Will Not Support The Dollar For Much Longer Repatriation Will Not Support The Dollar For Much Longer Repatriation Will Not Support The Dollar For Much Longer The euro will continue to behave as the anti-dollar, a consequence of the pair’s plentiful market liquidity. Moreover, the euro trades at a 17% discount to its purchasing power parity equilibrium. After last week’s rate cut and QE announcement, the European Central Bank has no more room to ease. Instead, the recent fall in peripheral bond spreads is loosening European financial conditions, which is boosting European growth prospects. This makes the euro more attractive. Bonds And Precious Metals Safe-haven yields will have significant upside in the coming 12 to 18 months. As we highlighted last month, bonds are so expensive, overbought and over-owned that they suffer from an extremely elevated probability of negative cyclical returns (Chart I-18, left and right panels). Moreover, excess reserves will once again grow when the Fed re-starts to expand its balance sheet. Higher excess reserves lead to a steeper yield curve slope (Chart I-19). Short rates have limited downside, therefore, the curve can only steepen via higher 10-year yields. Chart I-18AValuation And Technicals Point Toward Higher Yields In 12 Months (I) Valuation And Technicals Point Toward Higher Yields In 12 Months (I) Valuation And Technicals Point Toward Higher Yields In 12 Months (I) Chart I-18BValuation And Technicals Point Toward Higher Yields In 12 Months (II) Valuation And Technicals Point Toward Higher Yields In 12 Months (II) Valuation And Technicals Point Toward Higher Yields In 12 Months (II)   Chart I-19Fed Purchases Will Steepen The Curve Fed Purchases Will Steepen The Curve Fed Purchases Will Steepen The Curve Short-term dynamics are more complex. Treasury yields have climbed by 21 basis points since their September 3rd low, mostly on the back of decreasing trade tensions. In previous mid-cycle slowdowns, bond price tops only emerged after the ISM bottomed. We are not there yet. We expect substantial short-term volatility in yields in view of the unpredictable Sino-U.S. negotiations and the current lack of pick-up in global growth. During this transition process, cyclical investors should use bond rallies such as the current one to build below-benchmark duration positions in their fixed-income portfolios. Within precious metals, we continue to prefer silver to gold. We have favored precious metals since late June,6 but higher bond yields are negative for gold. However, central banks are maintaining a dovish bias aimed at lifting inflation breakevens back to their historical norm of 2.3% to 2.5%. This process increases the chance that the economy will overheat late next year. For the next 12 months, rising inflation expectations, not higher real rates, will push up bond yields. Combined with a weaker dollar, this configuration is mildly bullish for gold. Silver has a higher beta and more industrial uses than gold, which will allow for a period of outperformance if global growth increases. In this context, the silver-to-gold ratio, which stands at its 6th percentile since 1970, is an attractive mean-reversion play (Chart I-20). Chart I-20The Silver-Gold Ratio Is A Bargain The Silver-Gold Ratio Is A Bargain The Silver-Gold Ratio Is A Bargain Equities Investors should continue to favor stocks relative to bonds in the next year. Equities perform well up to six months before a recession starts (Table I-1). Moreover, our monetary and technical indicators are upbeat (see Section III). Additionally, sentiment surveys do not show rampant investor complacency (see Section III), which limits risks from a contrarian perspective. Meanwhile, yields have upside, which implies an outperformance of stocks versus bonds. Table I-1The S&P 500 Doesn’t Peak Until Six Months Before A Recession October 2019 October 2019 The short-term picture is more complex. P/E ratio expansion powered 90% of the S&P 500’s gains since it bottomed in December 24, 2018, and according to our model, U.S. operating earnings will contract for at least eight more months (Chart I-21). Thus, if yields mount through the rest of the year, multiples will likely contract. The S&P 500 is set to continue to churn over that time frame. Chart I-21U.S. Profits Still Have Downside U.S. Profits Still Have Downside U.S. Profits Still Have Downside In this context, strategy dictates investors focus on internal stock market dynamics. Namely, investors should favor financials and energy at the expense of tech and healthcare for the following reasons: Rising bond yields lift financials’ net interest margins. They also hurt multiples for tech stocks, which carry a large percentage of their intrinsic value in long-term cash flows and their terminal value. Thus, rising yields correlate with an outperformance of financials relative to tech (Chart I-22). Moreover, financials’ valuations and technicals are very depressed relative to tech, while comparative earnings estimates are equally morose (Chart I-23). Finally, our U.S. Equity Strategy team expects buybacks by financials to increase significantly.7 Chart I-22If Yields Rise, Financials Will Beat Tech If Yields Rise, Financials Will Beat Tech If Yields Rise, Financials Will Beat Tech Chart I-23Valuations, Technicals And Sentiment Favor Financials Over Tech Valuations, Technicals And Sentiment Favor Financials Over Tech Valuations, Technicals And Sentiment Favor Financials Over Tech     Rising yields also hurts healthcare stocks. Additionally, the rising popularity of Democratic progressives like Senator Elizabeth Warren requires investors embed a risk premium in the price of healthcare stocks (Chart I-24). The progressives want to nationalize healthcare insurance and compress healthcare profit margins, from drugs to hospitals. Chart I-24The Rise Of The Progressives Requires A Risk Premium In Health Care Stocks October 2019 October 2019 We have used energy stocks as a hedge against rising tensions in the Middle East. Now, our U.S. Equity Strategy colleagues have become more positive on this sector. Energy valuations and technicals are very attractive relative to the S&P 500 (Chart I-25).8 Energy stocks will outperform if global growth recovers and lifts global bond yields These sectoral recommendations argue investors should soon begin to favor European relative to U.S. stocks. Financials and energy are overrepresented in European equities while tech and healthcare are large overweight’s in the U.S. (Table I-2). Moreover, European activity is more sensitive to global economic momentum than the U.S. Thus, when global yields rally and the world economy stabilizes, European stocks will outperform their U.S. counterparts (Chart I-26). Additionally, European banks trade at 0.6-times book value which makes them the ultimate value play, one highly geared to easier European financial conditions and higher yields. Chart I-25Energy Is A Compelling Buy Energy Is A Compelling Buy Energy Is A Compelling Buy Table I-2Overweighting Europe Is Consistent With Our Sectoral Recommendations October 2019 October 2019 Chart I-26Europe Will Soon Outperform The U.S. Europe Will Soon Outperform The U.S. Europe Will Soon Outperform The U.S. Chart I-27Long-Term Investors Should Favor Stocks Over Bonds Long-Term Investors Should Favor Stocks Over Bonds Long-Term Investors Should Favor Stocks Over Bonds These sectoral biases are also consistent with value stocks outperforming growth equities. However, as Xiaoli Tang from BCA’s Global Asset Allocation service argues in Section II, the value-versus-growth question is a complex one that needs to be differentiated across geographies and equity size. Finally, long-term investors should also favor stocks over bonds. According to BCA Chief Global Strategist Peter Berezin, global stocks at their current valuations offer an expected 10-year real return of 4.2%. By historical standards, these are not elevated returns, but they are still much more generous than government bonds. Based on their dividend yields, U.S., Japanese and European equities need to fall by 18%, 28% and 40% before underperforming bonds on a 10-year basis, respectively.9 This is a large margin of safety (Chart I-27). We prefer foreign stocks with their more attractive valuations and local-currency expected returns. Additionally, the dollar is expensive and will weaken in a 5- to 10-year investment horizon. Mathieu Savary Vice President The Bank Credit Analyst September 26, 2019 Next Report: October 31, 2019   II. Value? Growth? It Really Depends! Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.10 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,11 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,12 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”13 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.14 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.15 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* October 2019 October 2019 Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”16 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* October 2019 October 2019 Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Fama-French Value-Growth-Size Peformance Dynamics* Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Small-Cap Value Growth Portfolios Small-Cap Value Growth Portfolios Chart II-2BLarge-Cap Value-Growth Portfolios* Large-Cap Value Growth Portfolios Large-Cap Value Growth Portfolios   The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria October 2019 October 2019 Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? Which Value/Growth? Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* October 2019 October 2019 In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Know Your Benchmark Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart II-5. Chart II-5Value/Growth: Russell Vs. S&P Value/Growth: Russell Vs. S&P Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.17 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Is Value Dead In DM? Is Value Dead In DM? Chart II-6BIs Value Dead In EM? Is Value Dead In EM? Is Value Dead In EM?   The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.18 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better October 2019 October 2019 Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* S&P Pure Styles* S&P Pure Styles* Chart II-7BRussell Pure Styles* Russell Pure Styles* Russell Pure Styles*   For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Valuation Is A Poor Timing Tool In The U.S. Valuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally Valuation Is A Poor Timing Tool Valuation Is A Poor Timing Tool   Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,19 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? How Good Is The Fit? How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.20, 21  This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* October 2019 October 2019 Chart II-10Prefer Sector And Country Positioning To Style Prefer Sector and Country Positioning To Style Tilts Prefer Sector and Country Positioning To Style Tilts We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President Global Asset Allocation III. Indicators And Reference Charts The S&P 500 will continue to churn this year. U.S. stocks have rebounded sharply through the month of September, yet, sentiment is neutral. Nonetheless, for now, stocks are likely to find it hard to meaningfully break above their July highs. Short-term momentum oscillators are overbought and U.S. profits still have downside. Because this year’s equity rally has been nearly entirely driven by multiples, this leaves equities vulnerable to any back-up in yields. As yields have not priced in any pick-up in growth, potential positive economic surprises are more likely to lift yields than stock prices. However, if growth disappoints, weak rates will cushion to blow to expected earnings. In line with this picture, our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields remain very depressed at highly stimulatory levels. Moreover, money growth has picked up around the world, and global central banks are cutting rates and expanding their balance sheets again. As a result, our Monetary Indicator remains at its most accommodative level since early 2015. Furthermore, our Composite Technical Indicator might not be improving anymore but it is still very much in constructive territory. Therefore, unlike four years ago, equities are more likely to avoid the headwind created by their overvaluation, especially as our BCA Composite Valuation index continues to improve.  10-year Treasurys may have cheapened a bit since last month, but they remain very expensive. Moreover, when current overvaluation levels are met by our technical indicator being as massively overbought as it is today, safe-haven bonds experience significant price declines over the following 12 months. That being said, the timing of a backup in yields is uncertain. If previous mid-cycle slowdowns are any guide, yields might need to wait for a bottom in the global manufacturing PMIs before rising freely. Nonetheless, the current setup argues against adding to long-duration bets. On a PPP basis, the U.S. dollar is only growing more expensive and the U.S. current account is deteriorating anew. For now, weak global manufacturing activity has helped the dollar stay well bid. However, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. This means that the dollar is highly vulnerable to any stabilization in growth. In fact, we would argue that the USD might prove to be the best variable to evaluate whether global growth is forming a durable bottom or not.   EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings   Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst Section I, “September 2019,” dated August 29, 2019, available at bca.bcaresearch.com 2       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 4              J. D. Hamilton, "Historical Oil Shocks," NBER Working Paper No. 16790. 5       Please see Geopolitical Strategy Special Report "Policy Risk, Uncertainty Cloud Oil Price Forecast," dated September 19, 2019, available at gps.bcaresearch.com 6       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 7       Please see U.S. Equity Strategy Weekly Report, “The Great Rotation,” dated September 16, 2019, available at uses.bcaresearch.com 8       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 11     Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 12     Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 13     Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 14      Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 15             Fama-French value-growth-size portfolios. 16     Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 17     Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 18     Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 19    Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 20     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 21     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993).

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades