Europe

Highlights Global bond yields have closely tracked the trajectory of global growth. While the global economy remains fragile, some positive signs are emerging: Our global leading economic indicator has moved off its lows; global financial conditions have eased significantly; U.S. household spending remains resilient; and China is set to further increase stimulus. Neither a severe escalation of the trade war nor a hard Brexit is likely. A simple comparison between current dividend yields and bond yields implies that global equities would need to fall by an outsized amount over the next decade for bonds to outperform stocks. As global growth stabilizes and then begins to recover over the coming months, bond yields will rebound from depressed levels. Investors should overweight stocks versus bonds for now, and look to upgrade EM and European equities later this year. Feature Global Growth Driving Bond Yields Chart 1Global Bond Yields: How Low Will They Go? Global Bond Yields: How Low Will They Go? Global Bond Yields: How Low Will They Go? Global bond yields rose sharply yesterday on word that U.S. and Chinese trade negotiators will meet in October. The announcement by China’s State Council of additional stimulus measures and better-than-expected data on the health of the U.S. service sector also drove the bond sell-off. The jump in yields follows a period of almost unrelenting declines. After hitting a high of 3.25% last October, the U.S. 10-year yield fell to 1.43% this Tuesday, just shy of its all-time low of 1.34% reached on July 5, 2016. The 30-year Treasury yield broke below 2% for the first time in history on August 15, falling to as low as 1.91% this week. It now stands at 2.07%. In Japan and across much of Europe, bond yields remain firmly in negative territory (Chart 1). The large movements in bond yields can be attributed to both the state of the global economy as well as to changes in how central banks are reacting to economic uncertainty. Just as stronger global growth pushed yields higher between mid-2016 and early-2018, the deceleration in growth since then has pulled yields lower. Chart 2 shows that there has been a close correlation between changes in the U.S. 10-year yield and the ISM manufacturing index. The release on Tuesday of a weaker-than-expected ISM manufacturing print for August was enough to push the 10-year yield down by seven basis points within a matter of minutes. Chart 2The Deceleration In Growth Has Pulled Yields Down The Deceleration In Growth Has Pulled Yields Down The Deceleration In Growth Has Pulled Yields Down The forward-looking new orders component of the ISM manufacturing index sunk to a seven-year low. The export orders component fell to the lowest level since 2009. Export volumes track ISM export orders quite closely (Chart 3). Not surprisingly, the ISM press release noted that trade remains “the most significant issue” for U.S. manufacturers. Chart 3Export Volumes Track The ISM Export Component Export Volumes Track The ISM Export Component Export Volumes Track The ISM Export Component The only redeeming feature in the report was that the customers’ inventories index dropped a notch from 45.7 in July to 44.9 in August. A reading below 50 for this subindex indicates that manufacturers believe that their customers are holding too few inventories, which is positive for future production. Global Manufacturing PMI Not Looking Much Brighter The Markit global manufacturing PMI remained below 50 for the fourth month in a row in August. While the global PMI did edge up slightly from July’s reading, this was largely due to a modest rebound in the Chinese PMI, which rose from 49.9 to 50.4. The improvement in the China Markit-Caixin PMI stands in contrast to the further deterioration observed in the “official” National Bureau of Statistics PMI. The former is more heavily geared towards private-sector exporting companies, and hence may have been influenced by the front-loading of exports ahead of the planned tariff increase on Chinese exports to the United States. Some Positive Signs Chart 4Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows In light of the disappointing manufacturing data, it is too early to call a bottom in the global industrial cycle. Nevertheless, there are some hopeful signs. Our Global Leading Economic Indicator (LEI) has moved off its lows (Chart 4). It usually leads the PMIs by a few months. Sterling will probably be the best performing currency in the G7 over the next five years. Despite ongoing weakness in the manufacturing sector, household spending has held up in most economies. In the U.S., the nonmanufacturing ISM index jumped to 56.4 in August from 53.7 in July. Real personal consumption is still on track to grow by 2.8% in Q3 according to the Atlanta Fed (Chart 5). The euro area services PMIs have also been resilient (Chart 6). In Germany, where the manufacturing PMI stood at 43.5 in August, the services PMI rose to 54.8.  Chart 5Inventories And Net Exports Have Subtracted From U.S. Growth In Q2 And Q3 Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) Global financial conditions have eased significantly, mainly thanks to the steep decline in bond yields. The current level of financial conditions implies that global growth could rebound swiftly (Chart 7). The Chinese government is also likely to step up fiscal/credit stimulus over the coming months in an effort to shore up growth. In a boldly worded statement released on Wednesday, the Chinese State Council promised to further increase bond issuance to finance infrastructure projects, while cutting interest rates and reserve requirements. A stronger Chinese economy should benefit global growth (Chart 8). Chart 7Easier Financial Conditions Will Benefit Global Growth Easier Financial Conditions Will Benefit Global Growth Easier Financial Conditions Will Benefit Global Growth Chart 8Stronger Chinese Growth Should Benefit The Global Economy Stronger Chinese Growth Should Benefit The Global Economy Stronger Chinese Growth Should Benefit The Global Economy   The Trade War: Moving Towards A Détente? The announcement that the U.S. and China will resume trade negotiations on October 5th is a step in the right direction. As we noted last week, both parties have an incentive to de-escalate the trade conflict. President Trump wants to prop up the stock market and the economy in order to improve his re-election prospects. China also wants to bolster growth.1 Chart 9Would China Really Be Better Off Negotiating With A Democrat As President? Would China Really Be Better Off Negotiating With A Democrat As President? Would China Really Be Better Off Negotiating With A Democrat As President? As difficult as it has been for China to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would be especially the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more palatable to deal with on trade matters. Does the Chinese government really want to negotiate over labor standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 9)? While Republicans in Congress would be able to restrain a Democratic president on domestic issues, the president would still enjoy free rein over trade policy.   Brexit Uncertainty Adding To Investor Angst Two weeks before the Brexit vote on June 23, 2016, I wrote that “Just like my gut told me last August that Trump would do much better at the polls than almost anyone thought possible, I increasingly feel that come June 24th, the EU may find itself with one less member.”2 Chart 10Brexit Opposition Has Been Growing Brexit Opposition Has Been Growing Brexit Opposition Has Been Growing Soon after the shocking verdict, we argued that a hard Brexit would prove to be politically infeasible, meaning that the U.K. would either end up holding another referendum or be forced to negotiate some sort of customs union with the EU. Our view that a hard Brexit will not happen has not changed. Chart 10 shows that opposition to Brexit has only grown since that fateful day. Boris Johnson does not have enough votes in Westminster to force a hard Brexit. Another election would not change this outcome, given that it would almost certainly produce a hung parliament. In any case, it is not clear that Johnson actually wants a hard Brexit. The Times of London recently reported that the government’s own contingency plans for a hard Brexit, weirdly code-named “Operation Yellowhammer,” predicted a crippling logjam at British ports leading to shortages of fuel, food and medicine.3  Boris Johnson is all hat and no cattle. He will be forced to make a deal with the EU. Buy the pound on any dips. Sterling will probably be the best performing currency in the G7 over the next five years. Central Banks: Cut First, Ask Questions Later Chart 11Inflation Expectations Are Low Across The Globe Inflation Expectations Are Low Across The Globe Inflation Expectations Are Low Across The Globe Despite a few glimmers of good news, central banks are in no mood to take any chances. St. Louis Fed President James Bullard said it bluntly last week: “Our job is to get the yield curve uninverted.”4 If history is any guide, global growth will stabilize and begin to recover over the coming months. Inflation expectations are below target in most economies (Chart 11). Central banks know full well that if the current slowdown morphs into a full-blown recession, they will be out of monetary ammunition very quickly. In such a setting, it does not make sense to hold your punches. Much better to generate as much inflation as possible, and as soon as possible, so that real rates can be brought deeper into negative territory if economic circumstances later warrant it. What If The Medicine Works? The risk of easing monetary policy too much is that economies will eventually overheat, producing more inflation than is desirable. It is easy to forget that the aggregate unemployment rate in the G7 is now below its 2007 lows (Chart 12). True, inflation has yet to take off, but this may simply be because inflation is a lagging indicator (Chart 13). Chart 12Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Chart 13Inflation Is A Lagging Indicator Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom For all the talk about how the Phillips curve is dead, the empirical evidence suggests it is very much alive and well (Chart 14). Ironically, this means that lower interest rates today could set the stage for much higher rates in the future if hyperstimulative monetary policies ultimately generate a bout of inflation.  Chart 14The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency   Investment Conclusions Like most economic forecasters, central banks tend to extrapolate recent trends too far into the future. Global growth has been weakening since early 2018 so it seems reasonable to assume that this trend will persist into next year. However, as we have documented, global industrial cycles tend to last about three years – 18 months of rising growth followed by 18 months of falling growth.5 If history is any guide, global growth will stabilize and begin to recover over the coming months. Should that occur, we will enter an environment where the lagged effects of easier monetary policy are hitting the economy just when the manufacturing cycle is taking a turn for the better. Stocks are likely to fare well in such a setting, while long-term bond yields will move higher. As a countercyclical currency, the dollar will also start to weaken anew (Chart 15). Granted, an intensification of the trade war or some other major adverse shock would upset this rosy forecast. Nevertheless, current market pricing offers a fairly large cushion against downside risks. Thanks to the drop in bond yields, the equity risk premium is quite high globally (Chart 16). Even if one were to assume that nominal dividend payments remain unchanged for the next ten years, the S&P 500 would still need to fall by more than 20% in real terms over the next decade for bonds to outperform stocks (Chart 17). Euro area stocks would need to drop by more than 42%. U.K. stocks would need to plummet by at least 60%! Chart 16AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 16BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Chart 17AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 17BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Investors should remain overweight stocks versus bonds over the next 12 months. We intend to upgrade EM and European equities once we see a bit more evidence that global growth has troughed.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “A Psychological Recession?” dated August 30, 2019. 2Please see Global Investment Strategy Weekly Report, “Worry About Brexit, Not Payrolls,” dated June 10, 2016. 3Rosamund Urwin and Caroline Wheeler, “Operation Chaos: Whitehall’s Secret No-Deal Brexit Preparations Leaked,” The Times, August 18, 2019. 4“Fed’s Bullard Sees ‘Robust Debate’ Over Half-Point Cut,” Bloomberg, August 23, 2019. 5Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Strategic Recommendations Closed Trades

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Such an environment is typically fertile ground for a dollar bull market, yet the trade-weighted dollar is up only 2.3% this year. The lack of more-pronounced strength in the greenback suggests that other powerful underlying forces are preventing the dollar from gapping higher. The breakdown in the bond-to-gold ratio is an important distress signal for dollar bulls. As both political and economic uncertainty remain elevated, likely winners in the interim remain safe-haven currencies such as the yen and the Swiss franc. For the remainder of the year, portfolio managers should focus on relative value trades at the crosses, rather than outright dollar bets. Stand aside on the pound for now. Aggressive investors can place a buy stop at 1.25 and sell stop at 1.20. The Riksbank’s hawkish surprise was a welcome development for the krona. Remain long SEK/NZD. The SEK might be the best-performing G10 currency over the next five years. Feature Yearly performance is an important benchmark for most portfolio managers. As most CIOs return to their desks from a summer break, they will be looking at a few barometers to help them navigate the rest of 2019. On the currency front, here is what the report card looks like so far: The dollar has been a strong currency, but the magnitude of the increase has been underwhelming, given market developments. The Federal Reserve’s trade-weighted dollar is up only 2.3% this year. In contrast, the yen is up 3.6% and the Canadian dollar 2.3%. Meanwhile, the best shorts have been the Swedish krona (down 9.7%) and the kiwi. Through the lens of the currency market, the dollar has been in a run-of-the-mill bull market, rather than in a panic buying frenzy (Chart I-1). Chart I-1A Report Card On Currency Performance Preserving Capital During Riot Points Preserving Capital During Riot Points Gold has broken out in every major currency. This carries a lot of weight because it has occurred amid dollar strength, a historical rarity. Importantly, the breakout culminates the seven-or-so-year pattern where gold was stable versus many major currencies (Chart I-2). We are no technical analysts, but ever since gold peaked in 2011, all subsequent rallies have seen diminishing amplitude, which by definition were bull traps. This appeared to have changed since 2015-2016, which could be a signal that the dollar bull market is nearing an end. Commodities have been a mixed bag. Precious metals have surged alongside gold. Despite the recent correction, oil is still up 13.8% for the year. Meanwhile, natural gas is in a bear market. Among metals, nickel has surged 70%, while Doctor Copper is down 5.1%. The only semblance of agreement is among soft commodities, which have been mostly deflating (Chart I-3). In short, there has been no coherent theme for commodity currencies. All the talk of a Sino-U.S. trade war, Chinese A-shares are up 18.7% for the year. This more than makes up for any CNY depreciation.  Equities have performed well across the board, mostly up double digits. The only notable laggards have been in Asia, specifically Japan, Hong Kong and Korea. That said, of all the talk of a Sino-U.S. trade war, Chinese A-shares are up 18.7% for the year. This more than makes up for any CNY depreciation. This also suggests that capital flows into equities have not been a major driver of currencies this year. Chart I-2Gold Has Been The Ultimate Currency Gold Has Been The Ultimate Currency Gold Has Been The Ultimate Currency Chart I-3Commodities Are A Mixed Bag Commodities Are A Mixed Bag Commodities Are A Mixed Bag Yields have collapsed, with higher-beta markets seeing bigger drops. Differentials have mostly moved against the dollar in recent weeks as the U.S. 10-year yield plays catch-up to the downside. One important question is that with Swiss 10-year yields now at -0.96% and German yields at -0.67%, is there a theoretical floor to how low bond yields can fall (Chart I-4)? Chart I-4Yields Have Melted Yields Have Melted Yields Have Melted Heading back to his office, the CIO is now pondering how to deploy fresh capital. On one hand, the typical narrative that we have been operating in the quadrant of a deflationary bust, given the trade war, manufacturing recession, political unrest and rapidly rising probability of recession is not clearly visible in financial data. This would have been historically dollar bullish, and negative for other asset classes. However, the plunge in bond yields begs the question of whether this is a prelude to worse things to come. A more sanguine assessment is that we might be at a crossroads of sorts. 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. 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. Time is of the essence, and strategy will be dependent on horizons. A review of the leading indicators for the major economic blocks is in order. Are We At The Cusp Of A Recession? Centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the currency world, this means that the tug of war between deteriorating global growth and easing liquidity conditions cannot last forever. Either the dollar breakout morphs into a panic buying frenzy or proves to be a bull trap. Are we at the cusp of a bottom in global growth, or approaching a riot point? Let us start with the economic front: U.S.: Plunging U.S. bond yields have historically been bullish for growth. More importantly, the recent decline in the ISM Manufacturing Index is approaching 2008 recessionary levels. Either easing in financial conditions revive the index, or the decoupling persists for a while longer. The tone on the political front appears reconciliatory, which means September and October data will be critical. In 2008, the divergence between deteriorating economic conditions and falling yields was an important signpost for a riot point (Chart I-5). Eurozone: The Swedish manufacturing PMI ticked up to 52.4 in August. Most importantly, the new orders-to-inventories ratio is suggesting that the German (and European) manufacturing recession is reversing (Chart I-6). For all the debate about whether China is stimulating enough or not, the beauty about this indicator is that there are no Chinese variables in it (the euro zone and Sweden export a lot of goods and services to China). Any surge higher in this indicator will categorically conclude the euro zone manufacturing recession is over, lighting a fire under the euro in the process. Whatever the number is, if it can stabilize Chinese growth, a powerful deflationary force that dictated markets in 2018-2019 will dissipate.  China: Chinese bond yields have melted alongside global yields. This is reflationary, given the liberalization in the bond market over the past few years. Policy makers are currently discussing the quota for next year’s fiscal spending. Whatever the number is, if it can stabilize Chinese growth, a powerful deflationary force that dictated markets in 2018-2019 will dissipate. Chart I-5Is U.S. Manufacturing Close ##br##To A Bottom? Is U.S. Manufacturing Close To A Bottom? Is U.S. Manufacturing Close To A Bottom? Chart I-6Is Eurozone Manufacturing Close To A Bottom? Is Eurozone Manufacturing Close To A Bottom? Is Eurozone Manufacturing Close To A Bottom? Discussions among industry specialists suggest some anecdotal evidence that many manufacturers have been engaged in re-routing channels and parallel manufacturing chains to avoid the U.S.-China tariffs. This is welcome news, since global exports and global trade are still in a downtrend. A key barometer to watch on whether the global slowdown is infecting domestic demand will be Chinese imports (Chart I-7). So far, the message is that traditional correlations have not yet broken down. As a contrarian, this is positive. Manufacturing slowdowns have tended to last 18 months peak-to-trough, the final months of which are characterized by fatigue and capitulation. However, unless major imbalances exist (our contention is that so far they do not), mid-cycle slowdowns sow the seeds of their own recovery via accumulated savings and pent-up demand. In the currency world, the dollar has tended to be an excellent counter-cyclical barometer. On the dollar, the bond-to-gold ratio is breaking down, in contrast to the rise in the DXY. This is not a sustainable divergence (Chart I-8). The last time the bond-to-gold ratio diverged from the DXY was in 2017, and that proved extremely short-lived. As global growth rebounded and U.S. repatriation flows eased, dollar support was quickly toppled over. Chart I-7Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Chart I-8Mind The Gap Mind The Gap Mind The Gap Ever since the end of the Bretton Woods agreement broke the gold/dollar anchor in the early 1970s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick-for-tick. While U.S. yields remain attractive, portfolio outflows and a deteriorating balance-of-payments backdrop will keep longer-term investors on the sidelines. Chart I-9Dollar Bulls Need A More Hawkish Fed Dollar Bulls Need A More Hawkish Fed Dollar Bulls Need A More Hawkish Fed Capital tends to gravitate towards higher returns, and the U.S. tax break in 2017 was a one-off that is now ebbing. Meanwhile, despite wanting to resist the appearance of influence from President Trump, the Fed realises that the neutral rate of interest in the U.S. is now below its target rate, which should keep them on an easing path. A dovish Fed has historically been bearish for the dollar (Chart I-9). Bottom Line: In terms of strategy, heightened uncertainty can keep the greenback bid in the coming weeks, but we will be sellers on strength. Our favorite plays remain the Swedish krona, the Norwegian krone, and, for insurance purposes, the Japanese yen. Outright dollar shorts await confirmation from more economic data. What To Do About CAD? The Bank of Canada (BoC) decided to stay on hold at its latest policy meeting. This was highly anticipated, but the silver lining is that the BoC might later reflect on this move as a policy mistake, given the arms race by other central banks to ease policy. The three most important variables for the Canadian economy are a:) what is happening to the U.S. economy, b:) what is happening to crude oil prices and c:) what is happening to consumer leverage and the housing market. On all three fronts, there has been scant good news in recent weeks. Heightened uncertainty can keep the greenback bid in the coming weeks, but we will be sellers on strength.  The Nanos Investor Confidence Index suggests Canadian GDP might be at the cusp of a slowdown after an excellent run of a few quarters (Chart I-10). One of the key drivers for the CAD/USD exchange rate is interest rate differentials with the U.S., and the compression in rates could run further (Chart I-11). Unless the BoC adopts a looser monetary stance, a rising exchange rate is likely to tighten financial conditions. Rising energy prices will be a tailwind, but the Western Canadian Select discount, and persistent infrastructure problems are headwinds. As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices. Chart I-10Canadian Data Has##br## Been Firm Canadian Data Has Been Firm Canadian Data Has Been Firm Chart I-11A Firm Exchange Rate Could Tighten Financial Conditions A Firm Exchange Rate Could Tighten Financial Conditions A Firm Exchange Rate Could Tighten Financial Conditions On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, but consumer confidence remains elevated given the robust labor market data (Chart I-12). However, if house prices continue to roll over, confidence is likely to crater (Chart I-13). Chart I-12Canada: Consumer Spending Is Weak Canada: Consumer Spending Is Weak Canada: Consumer Spending Is Weak Chart I-13Canada: The Housing Market Is Softening Canada: The Housing Market Is Softening Canada: The Housing Market Is Softening On the corporate side of the equation, the latest Canadian Business Outlook Survey suggests there has been no meaningful revival in capital spending. This is a big headwind, since Canada finances itself externally rather than via domestic savings. For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows (from bank shares) on a rate-of-change basis (Chart I-14). Chart I-14Foreign Investors Are Fleeing Canadian Securities Foreign Investors Are Fleeing Canadian Securities Foreign Investors Are Fleeing Canadian Securities Technically, the USD/CAD failed to break below the upward sloping trend line drawn from its 2012 lows, and the series of lower highs since the 2016 peak is forcing the cross into the apex of a tight wedge. The next resistance zone on the downside is the 1.30-1.32 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping We were stopped out of our short XAU/JPY position amid fervent buying in gold. Even though we are gold bulls, the rationale behind the trade was that the ratio of the two safe havens was at a speculative extreme. We will stand aside for now and look to re-establish the position in the near future. The Risksbank left rates on hold this week. This was welcome news for our long SEK/NZD position. The weakness in the SEK this year was expected given the surge in summer volatility, but the magnitude of the fall took us by surprise. In general, as soon as President Trump ramped up the trade-war rhetoric and China started devaluing the RMB, the environment became precarious for all pro-cyclical currencies. In terms of strategy going forward, the SEK probably has some additional downside, but not a lot. It is currently the cheapest currency in the G10. Should the Riksbank be actively trying to weaken the currency ahead of ECB policy stimulus this month, the final announcement, depending on what it entails, might be the bottom for the SEK and top for the EUR/SEK. Finally, as the Brexit drama unfolds, the outlook for the pound is highly binary. Aggressive investors can place a buy stop at 1.25 and a sell stop at 1.20. Anything in between should be regarded as noise.    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 firm: PCE deflator nudged up from 1.3% to 1.4% year-on-year in July. Core PCE was unchanged at 1.6% year-on-year. Michigan consumer sentiment index fell from 92.1 to 89.8 in August. Trade deficit narrowed marginally by $1.5 billion to $54 billion in July. Notably, the trade deficit with China increased by 9.4% to $32.8 billion in July. Initial jobless claims was little changed at 217 thousand for the past week. Unit labor cost increased by 2.6% in Q2. Nonfarm productivity remained unchanged at 2.3%. Factory orders increased by 1.4% month-on-month in July. More importantly on the PMI front, Markit manufacturing PMI was down from 50.4 in July to 50.3 in August. ISM manufacturing PMI deteriorated to 49.1 in August, while ISM non-manufacturing PMI increased to 56.4, up from the previous 53.7 and well above estimates. DXY index fell by 0.5% this week. The recent worries about a near-term recession since the 10/2 yield curve inverted last month has been supporting the dollar, together with possible additional tariffs against China and the Chinese yuan devaluation. Going forward, we believe the dollar strength will ebb, given fading interest rate differentials. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 Focusing On the Trees But Missing The Forest - August 2, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been firm: Unemployment rate was unchanged at 7.5% in July. Both headline and core preliminary inflation were unchanged at 1% and 0.9% year-on-year respectively in August. PPI fell from 0.7% to 0.2% year-on-year in July. On the PMI front, Markit composite PMI was little changed at 51.9 in August. Manufacturing component was unchanged at 47, while services component nudged up slightly to 53.5. Retail sales growth fell from upwardly-revised 2.8% to 2.2% year-on-year in July, still better than the estimated 2%. EUR/USD appreciated by 0.5% this week. While the manufacturing sector across Europe remain depressed, the services sector seems to be alive and well. The ECB monetary policy meeting next Thursday will be key for the path of the euro. 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 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Housing starts fell by 4.1% year-on-year in July. Construction orders increased by 26.9% year-on-year in July, a positive shift from 4.2% contraction in the previous month. Capital spending growth slowed to 1.9% in Q2. Manufacturing PMI fell slightly to 49.3 in August, while services PMI jumped from 51.8 to 53.3. USD/JPY increased by 0.5% this week. The consumption tax hike in Japan is scheduled for October 1. The tax rate will rise from 8% to 10%, with possible exemption on several goods such as food and non-alcoholic beverages, which could be a drag on domestic spending. That being said, we continue to favor the Japanese yen due to the risk of a recession amid the escalating global trade war. 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 Recent data in the U.K. continued to deteriorate: Nationwide house price index was unchanged in August. Markit composite PMI fell to 50.2 in August: Manufacturing component slowed to 47.4; Construction PMI fell to 45; Services component decreased to 50.6. Retail sales contracted by 0.5% year-on-year in August. GBP/USD increased by 1.2% this week. Brexit remains the biggest driver behind the pound. British PM Boris Johnson’s brother resigned this week, citing tension between “family loyalty” and “national interest”. Our Geopolitical Strategy upgraded a no-deal Brexit probability to about 33%, maintaining that it is not the base case since nobody wants an imminent recession. From a valuation perspective, the pound is quite cheap and currently trading far below its fair value. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 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: Building approvals keep contracting by 28.5% year-on-year in July. Australian Industry Group (AiG) manufacturing index increased to 53.1 in August. The services index soared to 51.4 in August from a previous reading of 43.9. Current account balance shifted to A$5.9 billion in Q2, the first surplus since 1975. Retail sales contracted by 0.1% month-on-month in July. GDP growth slowed down to 1.4% year-on-year in Q2, the lowest rate in over a decade. Exports and imports both grew by 1% and 3% month-on-month respectively. Trade surplus narrowed marginally to A$7.3 million. AUD/USD increased by 1.4% this week. While Q2 GDP growth rate continued to soften, the current account and PMI data are showing tentative signs of a recovery. On Monday, the RBA kept interest rates unchanged at 1%. In the press release, the Bank acknowledged that low income growth and falling house prices limited household consumption in the first half of the year. Going forward, the tax cuts, infrastructure spending, housing market stabilization, and a healthy resources sector should all support the Australian economy, and put a floor under the Aussie dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Consumer confidence improved slightly to 118.2 in August. Building permits continued to contract by 1.3% month-on-month in July. Terms of trade increased to 1.6% in Q2. NZD/USD increased by 1.2% this week. In a Bloomberg interview earlier this week, the New Zealand finance minister Grant Robertson expressed his confidence on the fundamentals of the domestic economy, especially the low unemployment rate and sound wage growth. The largest downside risk remains the global trade and manufacturing slowdown. As a small open economy, New Zealand is ultimately vulnerable to exogenous factors, especially those related to its large trading partners including U.S., China, and Australia. On the policy side, the finance minister believes that there is “still room to move” in terms of monetary policy. 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 mostly negative: Annualized Q2 GDP growth jumped from 0.5% to 3.7% quarter-on-quarter, well above estimates. Bloomberg Nanos confidence fell slightly from 57 to 56.4. Markit manufacturing PMI fell to 49.1 in August, right after a small rebound in July to 50.2.  Trade deficit widened to C$1.12 billion in July. USD/CAD fell by 0.5% this week. On Wednesday, BoC held its interest rate unchanged at 1.75%, as widely expected. In its monetary policy statement, the BoC sounded cautiously dovish, and expects economic activity to slow in the second half of the year amid global growth worries. The strong Q2 rebound was mostly driven by cyclical energy production and robust export growth, which could be temporary given the current market volatility. The rate cut probability next month is currently at 40%. 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 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 positive: KOF leading indicator was unchanged at 97 in August. Real retail sales grew by 1.4% year-on-year in July, up from the previous 0.7%. Manufacturing PMI increased to 47.2 in August, up from 44.7 in the previous month. Headline inflation remained muted at 0.3% year-on-year in July. GDP yearly growth slowed to 0.2% in Q2, from a downwardly-revised 1% in Q1. USD/CHF fell by 0.2% this week. We remain positive on the Swiss franc. The global economic slowdown and increasing worries about a near-term recession remain tailwind for the safe-haven franc.  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 Recent data in Norway have been mostly negative: Retail sales increased by 0.9% year-on-year in July. Current account surplus plunged by 60% from NOK 73.1 billion to NOK 30.6 billion in Q2, the lowest since Q4 2017. USD/NOK fell by 1.3% this week. The rebound in oil prices this week has supported petrocurrencies. On the supply side, the production discipline is likely to be maintained. On the demand side, fiscal stimulus globally should revive overall demand. A potential weaker USD should also support oil prices in the second half of the year, which will be bullish for the Norwegian krone. 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 mixed: Manufacturing PMI increased slightly to 52.4 in August, from 52 in the previous month. Current account surplus narrowed from SEK 63 billion to SEK 37 billion in Q2. Industrial production increased by 3.2% year-on-year in July. Manufacturing new orders increased by 0.4% in July compared with last month. However, on a year-on-year basis, it fell by 2.2%. The Swedish krona rallied this week, appreciating by 1.4% against USD. The Riksbank held its interest rate unchanged at -0.25% this Thursday, and stated that they still plan to raise interest rates this year or early next, but at a slower pace than the previous forecast. 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

HighlightsEuropean fiscal stimulus will not drive European equity outperformance – Europe needs China to open the stimulus taps.Our mega-theme of European integration continues – the continent is politically stable.The U.S.-China trade war is an opportunity for Europe. Any Sino-American trade deal is unlikely to resolve tech disputes. Go long European tech stocks versus American.The euro has room to grow as a global reserve currency given the dollar’s mounting structural flaws. Look for an opportunity to go long EUR/USD on a strategic basis within the near future.FeatureTalk of European fiscal stimulus is accelerating as investors look for reasons to take advantage of depressed European valuations (Chart 1) and traditional late-cycle outperformance relative to the U.S. (Chart 2). We are skeptical of the thesis. Chart 1European 'Cheapness' An Obvious Inducement European 'Cheapness' An Obvious Inducement European 'Cheapness' An Obvious Inducement   Chart 2Euro Stocks Outperform Late In The Cycle Euro Stocks Outperform Late In The Cycle Euro Stocks Outperform Late In The Cycle  Europe is a price taker, not a price maker, when it comes to global growth. In order for investors to generate alpha from an overweight Europe position, the rest of the world needs to pick up the slack and reverse the current decline in economic fundamentals. That will require policy action on the behalf of the Fed, the Trump administration, and – most relevant to Europe – Chinese fiscal policy.That said, long-term investors should start thinking about increasing exposure to Europe. Not only is the continent well priced relative to the rest of the world, but it may have two more things going for it. First, political risks remain low. Second, Europe stands to gain in any prolonged China-U.S. confrontation. The flipside risk is that it stands to lose enormously in any temporary resolution as well.Europe Is A Derivative – Not A Source – Of Global Growth…Despite accounting for 16% of global GDP, the Euro Area generates an ever-shrinking proportion of the annual incremental change in global GDP (Chart 3). This is not surprising, given that the world has undergone significant transformation due to China’s industrialization and the growth of EM economies. Chart 3Europe’s Contribution To Global Growth Declining Europe: Not A Price Maker Europe: Not A Price Maker  China’s imports today drive Euro Area manufacturing PMI broadly and Chinese retail sales drive German manufacturing orders specifically (Chart 4). As such, it is critically important to watch Chinese total social financing (TSF) impulse, which closely leads Europe’s exports to China by six months (Chart 5). Chart 4Europe And Germany Rely On China Europe And Germany Rely On China Europe And Germany Rely On China   Chart 5China's Credit Cycle Drives EU Exports China's Credit Cycle Drives EU Exports China's Credit Cycle Drives EU Exports   The problem is that the Chinese credit impulse has only tepidly recovered and implies more downside to European exports ahead. In addition, hopes of a rebound in Chinese retail sales have been dashed (Chart 6). The jump in auto sales in June was the result of heavy discounts offered by manufacturers and dealers to clear inventory before new emission standards came into effect on July 1. Due to the frontloading, car sales are now declining in what is traditionally an off-season for car purchases in China. While the worst may be over, weakness could linger for months. Chart 6China's Retail Sales Flashing Red China's Retail Sales Flashing Red China's Retail Sales Flashing Red  The bottom line is that without an upturn in global growth, Europe will remain in the doldrums. The good news is that BCA’s Chief Strategist Peter Berezin expects precisely such a development in the second half of 2019.1 The bad news is that Chinese credit stimulus appears to be weighed down by a combination of impaired transmission mechanisms and policymaker unwillingness to launch an old-school credit orgy (Chart 7). This is creating a highly unusual – for this cycle – development where China is not playing its usual counter-cyclical role amidst the global manufacturing cycle (Chart 8). Chart 7China's Credit Stimulus Restrained Thus Far China's Credit Stimulus Restrained Thus Far China's Credit Stimulus Restrained Thus Far   Chart 8Beijing Goes On Strike As Global Spender Beijing Goes On Strike As Global Spender Beijing Goes On Strike As Global Spender  Without more Chinese stimulus, European fiscal spending won’t be that meaningful.As such, it is difficult to get excited about European growth. As we discussed in last week’s missive, Europe is moving gingerly towards more fiscal spending. However, it has already done so this year, with fiscal thrust at 0.46% of GDP, the highest figure since 2009 (Chart 9). Did anyone notice? Not really. Chart 9Headwinds Overpower EU's Strong Fiscal Thrust Headwinds Overpower EU's Strong Fiscal Thrust Headwinds Overpower EU's Strong Fiscal Thrust  Moreover Euro Area countries have to submit their 2020 budgets in early Q4 to the European Commission. It is unlikely that these proposals will be meaningful, given that there is not yet enough panic to spur massive stimulus.Bottom Line: Yes, Europe will provide more fiscal spending in 2020. But it will remain at the mercy of global growth given its high-beta nature.…But At Least It Is Not Falling Apart!   That said, not all is disappointing on the Old Continent. For one, the aforementioned fiscal thrust at least prevented a deeper slowdown this year – and the drop-off in thrust next year will be less dramatic as budgets turn more accommodative.Meanwhile political risk is falling. Anti-establishment parties are either cleaning up their act, putting on a tie, and becoming part of the establishment, or they are losing power. Our long-held thesis that European integration would persist into the next decade remains well-supplied with empirical evidence.2On the Euroskepticism front, much of the hype today surrounds the collapse of the Five Star Movement (M5S) coalition with the League in Italy. The formerly Euroskeptic M5S has shed its critique of European integration and has decided to partner with the center-left and pro-establishment Democratic Party (PD).This is merely the tip of the iceberg. Several key developments throughout 2019 have signaled to investors that the Euroskeptic moment has passed. For a plethora of data and polling to support this view, please refer to our May report on the European Parliament (EP) election. Here we merely survey the latest developments:European Parliament Election: As expected in our EP election forecast, the May contest was a non-event. Support for the euro and the EU is trending higher (Chart 10 and 11), and 73% of Euroskeptic seats are held by Eastern European or U.K. MEPs (Chart 12), both irrelevant for EU policy.3  Chart 10Even Italy Swings In Favor Of Euro Even Italy Swings In Favor Of Euro Even Italy Swings In Favor Of Euro   Chart 11Public Opinion Supports The Union Public Opinion Supports The Union Public Opinion Supports The Union   Chart 12Euroskepticism Overstated Europe: Not A Price Maker Europe: Not A Price Maker  Random Elections: We rarely cover politics in Denmark or Finland, but the two Nordic countries have been at the forefront of the anti-establishment, right-wing, evolution in Europe. As such, the elections in Denmark (in June) and Finland (in April) were relevant. The Danish People’s Party (DPP) – one of the original “People’s Parties,” founded in 1995 – was massacred, losing 21 seats in the 179-seat legislature.In Finland, the moderately Euroskeptic Finns similarly saw a disappointing – if not as disastrous – performance.Finally, Austrian election on September 29 will likely see the other Europe’s prominent right-wing, Euroskeptic, party – the Freedom Party of Austria (FPO) – decline below 20% for the first time since 2008. Chart 13Macron Recovering In Polls Macron Recovering In Polls Macron Recovering In Polls  France: Our high conviction view in February that the Yellow Vest protest would ultimately dissipate proved correct. President Emmanuel Macron has also seen a recovery in polling. Although tepid, at least he appears to be diverging from the trajectory of his disastrously unpopular predecessor François Hollande (Chart 13).The good news for Macron is that he continues to lead Marine Le Pen by double digits in the theoretical 2022 second round. While this represents a considerable improvement for Le Pen from her 2017 performance, the fact is that she has had to adjust her policies and rebrand the National Front in order to close the gap with Macron. The party is now called the National Rally and has publicly revised its stance towards both the EU and the euro.4The events in France, Denmark, Finland, and Austria have largely gone unnoticed amidst the China-U.S. trade war, attacks against Federal Reserve independence, and general breakdown in global institutions and paradigms. But they reveal that Euroskepticism in Europe is evolving from a definitive one – in or out – to a much more nuanced position.For students of history, this is not a surprise. European integration has always been a push-pull process. Charles de Gaulle famously caused a total breakdown in integration during the 1965 “Empty Chair Crisis” when France recalled its representative in Brussels and refused to take its seat on the Council.De Gaulle was a Euroskeptic in so far as he believed that European integration was a national, not a supra-national process.5 It could proceed apace, but only if controlled by national capitals. As such, he warred with the Commission all the time. However, de Gaulle did not want to eliminate European integration as he understood its geopolitical and economic imperative. He simply wanted to shape the process to fit French interests.Absolutist Euroskepticism – the idea that all European institutions ought to be replaced by national ones – is an alien idea to the post-World War Two continent, one imported from the nineteenth century. The irony of Brexit, therefore, is that the most vociferous supporters of an absolute end to the EU integrationist project are now abandoning their fellow absolutists on the continent.Geopolitical and structural factors are also pushing European Euroskeptics to evolve from absolutists to modern-era Gaullists. We have identified most of these factors before, but they are worth repeating:Europe has a geopolitical imperative to integrate. In a multipolar world dominated by global powers like the U.S. and China – and with Russia, India, Japan, Iran, and Turkey playing an increasingly independent role – European states are not large enough on their own to defend their economic and geopolitical interests. Chart 14Geopolitical Forces Behind Integration Geopolitical Forces Behind Integration Geopolitical Forces Behind Integration  The purpose of integration is to aggregate the geopolitical power of Europe’s individual states amidst rising global multipolarity. Chart 14 is a stylized visualization of what European integration is attempting. It illustrates that the average BCA Geopolitical Power Index (GPI) score of an EMU-5 country is well below that of a BRIC state.6 By aggregating their geopolitical power, European states retain some semblance of relevance in the world.Obviously this is merely a thought experiment as European integration is not aggregation and never will be. Not only is aggregation politically unfeasible, but there is also a lot of double counting in simply adding GPI scores of European states. Nonetheless, the point is that European countries are asymptotically moving from the average to the aggregate score. Chart 15No Basis For Fascism In Great Recession No Basis For Fascism In Great Recession No Basis For Fascism In Great Recession  No, the Nazis are not coming. Europe has managed to recover from a generational financial crisis. Pessimists point to the depth of the crisis to explain why Europe is unsustainable, with angst matching the severity of the downturn. However, analogizing to the 1930s is folly. First, Europe’s shared memories of the ravages of populism act as antibodies preventing precisely the same infection from breaking out on the continent.7 Second, the European financial crisis was simply nowhere close to the depth of the Great Depression that rocked Germany as it descended into National Socialism (Chart 15). As for the argument that the European Central Bank fed populism through unorthodox policy easing, the tide of populism would have been much more formidable if Europe had been allowed to sink into deeper recession and deflation.Europeans are just not that desperate. Europe scores much better than the U.S. (or the U.K.) when it comes to the balance between the median income and middle-income share of total population. Chart 16 shows that most Euro Area economies have around 70% of their population in the middle-income bracket. Those that fall short nonetheless hug the line of best fit closely (Italy, Spain, Greece, and the Baltic States). The U.S., on the other hand, has one of the highest median income levels, but with barely 50% of the population considered in the middle-income. Meaning that a lot of the people below the median line are far below it. This is a recipe for actual populist political outcomes (President Trump), as opposed to artificial ones (Italy). Chart 16U.S. At Greater Risk Of Populism Than EU Europe: Not A Price Maker Europe: Not A Price Maker  European populism is artificial, U.S. populism is actual.What of the risks in Europe? For example, investors are concerned about mounting Target2 imbalances. Here we agree with our colleague Dhaval Joshi, who has pointed out that growing imbalances in Europe’s monetary system will only further constrain centrifugal forces among the nations.Target2 has seen a steady outflow of Italian cash to German banks as the ECB’s QE saw respective central banks purchase domestic bonds (Chart 17). This means that the Bank of Italy holds assets – BTPs – denominated in Italian euros, while the Bundesbank has a new liability to German banks denominated in German euros. EMU dissolution would be too painful due to this mismatch. Target2 is therefore not a threat to the EMU, but rather a Gordian Knot that can only be unraveled with immense pain and violence.That said, there may be an upcoming headline risk in Europe: the end of Chancellor Merkel’s reign. In our view, Merkel’s role in stabilizing Europe is greatly overstated. Her dithering and lack of conviction caused several crises to descend into chaos amidst the sovereign debt imbroglio. As such, an infusion of new blood will be positive for Europe. The populist threat is also overstated, with the Alternative for Germany (AfD) performing relatively tepidly in the polls. In fact, the liberal, Europhile, Greens are starting to gain votes (Chart 18). As such, an early election in Germany would create volatility and uncertainty but would not undermine our secular thesis on Europe. Chart 17Gordian Knot Supports Integration Gordian Knot Supports Integration Gordian Knot Supports Integration   Chart 18Germany Not Falling To Populism Germany Not Falling To Populism Germany Not Falling To Populism  Bottom Line: There is an ever-strengthening case for the sustainability of the Euro Area and European integration well into the next decade.From Geopolitical Gambit To A Geopolitical Safe-Haven?At this point, we have built a strong case for why Europe will remain a high-beta play on global growth that is unlikely to collapse. As such, investors should plow into Europe when the rest of the world is doing well with confidence that the continent will not descend into chaos.The U.S.- China trade war offers an intriguing opportunity for Europe.This is largely underwhelming as an investment thesis. Could there be something more exciting to the story given a slew of well-known headwinds to European growth from demographics, low productivity, and regulatory malaise?The trade war between the U.S. and China does offer an intriguing opportunity for Europe.There appears to be an interesting development where European equities outperform those of the U.S. during periods of trade war turbulence (Chart 19). The outperformance is not major, but it is highly counterintuitive. Chart 19Europe Outperforms Amid Trade War Shocks Europe Outperforms Amid Trade War Shocks Europe Outperforms Amid Trade War Shocks  As is understood, Europe is a high-beta play on global growth. Presumably, investors should abandon high-growth derivative plays when trade war accelerates. It is one of the reasons that EM equities and EM FX suffer whenever trade war accelerates.So why is Europe different? Because European exporters generally compete with their American counterparts (and Japanese and South Korean) for Chinese market share. And if China retaliates against U.S. companies, European companies stand to benefit, potentially massively.Take Boeing and Airbus. Boeing expects China to demand 7,700 new airplanes over the next two decades, an order valued at $1.2 trillion. It would be disastrous to the U.S. airline industry if the entirety of that order went to Airbus and its subsidiaries.8 According to the latest news reports, China has slowed down its airplane procurement to a crawl as it awaits the outcome of the dispute with the U.S.9 It is predictably using the procurement decision as leverage in the negotiations. Chart 20Europe To Lose If China Strikes U.S. Deal Europe To Lose If China Strikes U.S. Deal Europe To Lose If China Strikes U.S. Deal  Yet this “substitution effect” thesis is a double-edged sword for Europe. A resolution of the trade war between the U.S. and China would likely include a massive purchase of U.S. agricultural, commodity, and manufacturing goods: the so-called “Beef and Boeings” deal. China bears often point out that such a massive purchase will negatively impact China’s current account, which is barely in surplus thanks to China’s trade surplus with the U.S. (Chart 20). This is false. Chinese policymakers are not suicidal. The last thing China needs is a balance of payments crisis due to a trade deal with the U.S.China would simply rob Peter to pay Paul, pulling its orders of soy from Brazil and Airbus from Europe in order to make a deal with the U.S. As such, it is highly likely that European capital goods exporters would suffer in any trade war resolution between China and the U.S.That said, a substantive trade deal that resolves all U.S.-China tensions is extremely unlikely. The U.S. and China are not just commercial rivals, they are also geopolitical rivals. As such, the tech conflict between the U.S. and China will continue well beyond any resolution of the trade war. This could create an opportunity for Europe’s traditionally beleaguered tech stocks to finally outperform their American counterparts (Chart 21). Chart 21Go Long EU Tech Versus U.S. Tech Go Long EU Tech Versus U.S. Tech Go Long EU Tech Versus U.S. Tech  Bottom Line: A deterioration of the U.S.-China trade relationship would be a boon for European exporters. Short of a total breakdown of U.S.-China trade, however, European tech stocks may finally begin outperforming their U.S. counterparts thanks to the open distrust between U.S. and China.In addition, U.S. technology firms are likely going to face a slew of regulatory challenges over the next decade. While not necessarily negative, these challenges will nonetheless create new headwinds for the sector.10 We are therefore initiating a structural theme of being long European tech relative to U.S.Investment ImplicationsAre there any broader themes to be extracted from the combined geopolitical forecasts presented in this report? Europe will not collapse, and it may benefit from the souring of U.S.-China geopolitical and economic relations.Long euro is an obvious theme. As our colleague Dhaval Joshi has recently pointed out, the chasm between monetary policies of the Fed and the ECB has become a major geopolitical risk. This is because it has depressed the euro versus the dollar by at least 10 percent – based on the ECB’s own competitiveness indicators. The exchange rate distortion stemming from polarized monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart 22).In the short term, EUR/USD may have reached its practical (and geopolitically acceptable) lows. Yes, the ECB is readying another round of monetary stimulus on September 12, but the fiscal policy counterpart is likely to be tepid and thus fail to (yet again) take advantage of historically depressed borrowing costs on the continent. The September 12 ECB meeting may therefore be a “sell the rumor, buy the news” event for EUR/USD. Chart 22Monetary Policy Accounts For Bilateral Surplus Monetary Policy Accounts For Bilateral Surplus Monetary Policy Accounts For Bilateral Surplus   Chart 23U.S. Rivals Buying Gold, Ditching Dollar U.S. Rivals Buying Gold, Ditching Dollar U.S. Rivals Buying Gold, Ditching Dollar  On the more cyclical and secular horizon, we see an opportunity for the euro to reestablish some of its lost reserve currency status due to the geopolitical conflict between China and the U.S. Washington’s willingness to use trade and financial sanctions for geopolitical benefit has given pause to central bank authorities around the world in using dollars as a reserve currency. Purchases of gold for FX reserve have surged, particularly among America’s geopolitical rivals (Chart 23), as our colleague Chester Ntonifor has recently pointed out.As we argued in a report entitled “Is King Dollar Facing Regicide?” the euro has some catch-up potential. In 1990, the combined currencies of the countries that today comprise the Euro Area accounted for 35% of total composition of global currency reserves. Today, the figure is merely 20% (Chart 24). Chart 24Euro Has Plenty Of Room To Grow As Reserve Currency Europe: Not A Price Maker Europe: Not A Price Maker  Could Europe supply the world with enough euros to replace USD as a reserve currency? This is highly unlikely. However, at the margin, an expansion of European liquidity is possible, particularly if Germany finally learns to love fiscal expansion and if European policymakers capitulate on the issuance of Eurobonds. However, such a lack of euro liquidity is not negative for the euro. The world could soon experience a situation where the demand for non-USD liquid assets dramatically increases due to the politicization of America’s reserve currency status while the supply of USD-alternatives remains relatively low. This should be positive for the only true alternative to the USD as a global reserve currency: the euro.As such, we will be looking to initiate a strategic long EUR/USD position, potentially sometime this fall as the ECB and FOMC meetings take place and the risk of a no-deal Brexit is averted. We do not expect the massive monetary policy divergence between Europe and the U.S. to continue, while the Euro Area’s political stability, and the broader geopolitical demand for a non-USD reserve currency, create more long-term tailwinds for the euro.Marko PapicConsulting Editor, BCA Research              Chief Strategist, Clocktower GroupHousekeepingOur high-conviction view that no-deal Brexit odds were overrated has been confirmed by the recent events in the U.K. parliament. We are going long GBP-USD with a tight stop-loss of 3%. Since we expect further volatility – with an election likely and the Conservative Party performing well in the polls and monopolizing the Brexit vote in a first-past-the-post system – we will sell at the $1.30 mark.Footnotes1 Please see Global Investment Strategy, “Trade War: The Storm Before The Calm,” dated August 9, 2019, available at gis.bcaresearch.com.2 Please see Geopolitical Strategy, “Europe's Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011, available at gps.bcaresearch.com.3 The reason we extracted the U.K. Euroskeptics from the calculation is because with Brexit nigh, the U.K. members of European Parliament are no longer policy relevant. As for Central European Euroskeptics, we extracted them because they are irrelevant for EU policy as they hail from member states that – in truth – nobody seriously thinks would ever leave the EU.4 Ahead of the May EP election, National Rally electoral platform focused on “local, ecological, and socially responsible production." The party advocates combining environmentalism with protectionism, creating an ecological custom barrier at the EU’s doorstep which would defend the European market from products manufactured or produced with less environmentally friendly processes. On the matters of EU membership, the party now advocates a more traditionally Euroskeptic line, a purely Gaullist form of Euroskepticism that seeks to curb – or, at best, abolish – the EU Commission and replace its legislative prerogative by giving the Council of the EU all legislative powers. 5  Please see Julian Jackson, De Gaulle (Cambridge, MA: Harvard UP, 2018).6 We chose to use EMU-5 in the chart because it focuses on the top-five economies in the Euro Area: France, Germany, Italy, Spain, and the Netherlands. If we focused on the overall average EMU score, even one we weighed by population, the results would be even more stark in terms of loss of importance.7 And, worryingly, the U.S. lacks precisely the same shared memory of how wild pendulum swings of polarization can descend into extreme nationalism or left-wing extremism.8 Airbus would not have the capacity to fulfill that entire order today. However, demand creates its own supply, giving Airbus a reason to surge capex and reap the profits.9 Please see Reuters, “Exclusive: Boeing CEO eyes major aircraft order under any U.S.-China trade deal.”10 Please see Geopolitical Strategy, “Is The Stock Rally Long In The FAANG?,” dated August 1, 2018 and “Surviving A Breakup: The Investor’s Guide To Monopoly-Busting In America,” dated March 20, 2019, available at gps.bcaresearch.com.

Highlights An inevitable and imminent U.K. general election will be one of the most unpredictable and ‘non-linear’ elections ever. This non-linearity makes it difficult to take a high-conviction view on sterling’s direction because a tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30. Instead, a good strategy is to buy sterling volatility on the announcement of the election. The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). In a soft Brexit or remain, the U.K. equity sectors most likely to outperform the overall market are real estate and general retailers. In a hard Brexit, a U.K. sector likely to outperform the overall market is clothing and accessories. Feature Chart of the WeekSterling Volatility Could Go Up A Lot Sterling Volatility Could Go Up A Lot Sterling Volatility Could Go Up A Lot Lyndon B Johnson famously said that that the first rule of politics is to learn to count. A government is a lame duck if it does not have a majority of legislators to drive and set its policy. Fifty years on, LBJ’s namesake is learning this first rule of politics. Boris Johnson is running a minority U.K. government. The irony is that this makes it impossible for a pro-Brexit Johnson to pass legislation for the Brexit process itself! Ending the free movement of EU citizens was supposedly one of the biggest ambitions of the Brexit vote. But astonishingly, even after a no-deal Brexit, free movement would not end – because EU law continues to apply until its legal foundation is repealed. The U.K. government wanted to end free movement through a new law, the immigration bill, but the proposed legislation, along with several other key new laws, cannot make it through parliament. The Most Non-Linear Election Looms The only way out of the impasse is to change the parliamentary arithmetic via a snap general election. The trouble is that the outcome of such an election is near impossible to predict. This is because the U.K.’s first past the post electoral system is designed for a head-to-head between two dominant parties. But right now, there are four parties in play – from left to right: Labour, Liberal Democrat, Conservative, and Brexit. While in Scotland, the SNP is resurgent. Making the next U.K. general election one of the most unpredictable and ‘non-linear’ elections ever. The outcome of a snap general election is near impossible to predict. For example, in the recent Brecon and Radnorshire by-election, the 10 percent of votes that went to the Brexit party syphoned just enough ‘leave’ votes from the Conservatives to hand the seat to the Lib Dems. Repeated nationwide, such a swing could inflict mortal damage to the Conservatives. On the other hand, the staunchly pro-remain Lib Dems could also syphon crucial votes from a Labour party that is prevaricating on its Brexit policy. Understanding this, Johnson isn’t using the next election to resolve Brexit; quite the opposite, he is using Brexit to resolve the next election – in his favour – with the ancient strategy of ‘divide and rule’. Unite ‘leave’ by tacking to the hard right, and divide ‘remain’ between Labour, Lib Dem, Green, SNP, and Plaid Cymru. However, it is a very risky strategy. A small but critical rump of Brexit party voters are diehard anti-establishment rather than pure leave votes; furthermore, remainers almost certainly will vote tactically as they did in 2017 when they obliterated the Conservatives’ overall majority. For U.K. investments, the inevitable imminent election dominates all other considerations, as its outcome will determine the U.K.’s ultimate trading relationship with the EU and rest of the world, as well as establish the U.K’s overarching economic policy and strategy. But to reiterate, the outcome is highly non-linear. A tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30, as sterling’s ‘Brexit discount’ is unwound (Chart I-2 and Chart I-3). Chart I-2Sterling's Brexit Discount Is 15 Percent, Based On Real Interest Rate Differentials... Sterling's Brexit Discount Is 15 Percent, Based On Real Interest Rate Differentials... Sterling's Brexit Discount Is 15 Percent, Based On Real Interest Rate Differentials... Chart I-3...And Expected Interest Rate ##br##Differentials ...And Expected Interest Rate Differentials ...And Expected Interest Rate Differentials The non-linearity makes it difficult to take a high-conviction view on sterling’s direction. Instead, as soon as an election is announced, a good strategy is to buy sterling volatility. Although it has risen recently, sterling volatility is only in the foothills relative to the heights of 2016, meaning plenty of upside (Chart I-1). The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). Brexit Investments  A common question we get is what are the most Brexit-impacted investments, in both directions? As mentioned, the most obvious is sterling. Relative to the established relationship with interest rate differentials prior to the Brexit vote in 2016, the pound now carries a Brexit discount of around 15 percent. For U.K. investments, the inevitable imminent election dominates all other considerations. Related to this, the FTSE100 has outperformed the Eurostoxx600. This is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of global multi-currency earning companies quoted in pounds and euros respectively. So when sterling weakens, the multi-currency earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in FTSE100 outperformance (Chart I-4). Chart I-4The FTSE100 Outperforms When Sterling Weakens The FTSE100 Outperforms When Sterling Weakens The FTSE100 Outperforms When Sterling Weakens Turning to U.K. equity sectors, those most likely to outperform the overall market in a soft Brexit are real estate and general retailers (Chart I-5 and Chart I-6). Chart I-5U.K. Real Estate Outperforms In A Soft Brexit U.K. Real Estate Outperforms In A Soft Brexit U.K. Real Estate Outperforms In A Soft Brexit Chart I-6U.K. General Retailers Outperform In A Soft Brexit U.K. General Retailers Outperform In A Soft Brexit U.K. General Retailers Outperform In A Soft Brexit While a sector likely to outperform the overall market in a hard Brexit is clothing and accessories (Chart I-7). Chart I-7U.K. Clothing And Accessories Could Outperform In A Hard Brexit U.K. Clothing And Accessories Could Outperform In A Hard Brexit U.K. Clothing And Accessories Could Outperform In A Hard Brexit Four Disruptors Revisited The final section this week revisits the wider context for Brexit and other recent examples of populism. Specifically, they are backlashes to four structural disruptors to economies and financial markets. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left many people’s standard of living stagnant – despite seemingly decent headline economic growth and job creation (Chart I-8). Chart I-8Disruptor 1: Income Inequality Leads To Protectionism Disruptor 1: Income Inequality Leads To Protectionism Disruptor 1: Income Inequality Leads To Protectionism Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in several major economies: the U.S., U.K., Italy, and Brazil. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that the malaise is being misdiagnosed. Many middle-income job losses are not due to globalization, but due to technology. A polarised distribution of economic growth has left many people’s standard of living stagnant. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs – like bartending and waitressing – which AI cannot (yet) replace (Table I-1). And AI’s impact on middle-income jobs is only in its infancy.1 The worry is that by misdiagnosing the illness as globalization and wrongly responding with protectionism, the illness will get worse, rather than improve. Table I-1Disruptor 2: Technology Brexit: Rock Meets Hard Place Brexit: Rock Meets Hard Place Disruptor 3: Debt super-cycles have reached exhaustion. Protectionism carries a further danger. Just like developed economies did a decade ago, major emerging market economies are now coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown.  Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Financial markets are richly valued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Extremely compressed risk premiums are justified so long as bond yields remain ultra-low. Otherwise, the rich valuations will come under pressure.  Chart I-10Disruptor 4: Financial Markets Are Richly Valued Disruptor 4: Financial Markets Are Richly Valued Disruptor 4: Financial Markets Are Richly Valued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to follow bespoke structural investment themes as shown in our structural recommendations section. Please note that owing to my travelling there is no fractal trading system this week. Normal service will resume next week.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘The Superstar Economy: Part 2’ January 19, 2017 available at eis.bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Four ghosts of 2016 are knocking at the door: Brexit, Trump, Brazil, Italy. President Trump and U.S. trade policy are keeping uncertainty high. Upgrade the odds of a no-deal Brexit to about 33%. Expect limited stimulus from Italy and Germany – for now. Brazil’s pension reform is entering its final stretch – buy the rumor, sell the news. Feature Four major political events of 2016 are returning to affect the global investment landscape this fall – though only two of these ghosts are truly frightening. In order of market relevance: Trump: The election of Donald J. Trump as U.S. president, November 8, 2016 Brexit: The U.K. referendum to leave the European Union, June 23, 2016 Italy: The Italian constitutional referendum, December 4, 2016 Brazil: The removal of Brazilian President Dilma Rousseff, August 31, 2016 Italy and Brazil are producing market-positive political results in the short run. Brexit and Trump pose substantial and immediate risks to the global bull market. A pivot by Trump is the headline risk to our view that no trade agreement will be concluded by November 2020, as we outlined in a Special Report last week. At the moment tensions are still escalating. President Trump has ordered an increase in tariffs (Chart 1) and threatened to invoke the International Economic Emergency Powers Act of 1977, which would give him the ability to halt transactions, freeze funds, and appropriate assets. China is retaliating proportionately and virtually incapable of softening its tone prior to its National Day celebration on October 1. The next round of negotiations, slated for Washington in September, could be a flop like the talks in July, or it could be canceled. Investors should stay defensive. The equity market will have to fall to force Trump to stage a tactical retreat. Meanwhile China could intervene violently in Hong Kong SAR. That possibility, the nationalist military parade on October 1, and U.S. actions toward the South China Sea and Taiwan, show that sabers are rattling, causing additional market jitters. Chart 1Trump's Latest Tariff Salvo Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 U.S.-China tensions underpin our tactical safe-haven trade recommendations. But we are not shifting to a cyclically bearish stance until we get clarity on Trump’s and Xi’s handling of their immediate predicament. Brexit is the other acute short-term risk. This was true even before Prime Minister Boris Johnson opted to prorogue parliament from September 10 to October 14, shortening the time that parliament has to either pass a law forbidding a no-deal exit or bring down Johnson’s government in a vote of no confidence. We are upgrading the odds of “no deal” to no higher than 33%, using a conservative decision-making process (Diagram 1). No-deal is not our base case because parliament, the public, and even Johnson himself want to avoid a recession, which is the likely outcome, even granting that the Bank of England will not stand idly by. We are upgrading the odds of “no deal” Brexit to about 33%. Diagram 1Brexit Decision Tree (Revised August 29, 2019) Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 From a bird’s eye point of view, the pound is very attractive (Chart 2). But in the near-term the twists and turns of Britain’s political struggle imply that we will see wild volatility. Our foreign exchange strategists expect that a no-deal Brexit would cause GBP/USD to collapse to 1 after October 31. Assuming our one-in-three odds of such an outcome, the probability-weighted average of cable is about 1.2. Hence investors should not short sterling from here, unless they strongly believe we are underrating the odds of no-deal exit. In the worst-case scenario, a no-deal Brexit will cause an economic shock at a time when Europe is on the brink of recession – Italy and Germany are virtually there. This means there is a substantial risk of additional deflationary pressure piling onto German bunds and sustaining the global bond rally. This pressure will be sharply reduced if Johnson loses an early no confidence vote, but that is a 50/50 call so we would not call time on this rally yet. Stay cautious. Chart 2Pound Can Only Go So Low Pound Can Only Go So Low Pound Can Only Go So Low   Italy: Stimulus … Without A Bruising Brussels Battle Italy has avoided a new election by producing an unusual tie-up between the establishment Democratic Party and the anti-establishment Five Star Movement (M5S). The coalition still needs to clear some internal hurdles and an online vote by Five Star members, but an agreement is to be presented to President Sergio Mattarella as we go to press. This is the most market-friendly outcome that could have been expected, as is clear through the sharp drop in Italian government bond yields (Chart 3). Our GeoRisk indicator for Italy is also collapsing. Chart 3Markets Cheer New Italian Coalition Markets Cheer New Italian Coalition Markets Cheer New Italian Coalition This development marks the climax of a story line that we outlined in 2016, when Prime Minister Matteo Renzi lost a constitutional referendum that aimed to strengthen Italian governments to enable deeper structural reforms (he subsequently resigned). At that time we argued that Italy would emerge as a market-relevant political risk due to rampant anti-establishment sentiment, but that this risk would subside when Italy’s populists were shown to be pragmatic at heart, i.e. unwilling to push their conflicts with Brussels to a point that truly reignited European break-up risk. This view is now vindicated – and not only for the short-term. The new coalition comes at the nick of time, with Europe teetering on recession and the risk of a no-deal Brexit rising. The new government will have to deliver the 2020 budget to the European Commission by October 15. The budget will aim to provide fiscal support, including a delay of the legislatively mandated hike in the Value Added Tax from 22% to 24.2%, already rolled over from 2019. The Five Star Movement will demand as a price for its participation in the coalition that social spending go up; the Democratic Party will have learned a lesson while out of power and will be more fiscally permissive and strike a tougher tone with Brussels. The Italian budget talks will be a non-issue: the coalition will cooperate with Brussels. The episode demonstrates that the Italian risk to financial markets is overrated. This point goes beyond the fact that the Democrats and Five Star were able to cooperate. Italy’s leading populist parties have already shown that they are pragmatic and will play the game with Brussels to avoid a financial breakdown. In May 2018, the newly formed populist coalition proposed a gigantic “wish list” budget that would have increased the budget deficit to roughly 7.3% of GDP in 2019. They also appointed a euroskeptic economy minister who almost prevented government formation. The ensuing conflict with Brussels triggered considerable turmoil (Chart 4). Ultimately, however, the populists did precisely what we expected: they bowed to the severe financial constraint on Italy’s banking system. They agreed to a 2019 and 2020 deficit of 2.04% and 2.1%, respectively (Chart 5). Chart 4Italian Populists Prove Pragmatic Italian Populists Prove Pragmatic Italian Populists Prove Pragmatic Chart 5Even Salvini Compromised On Budget Clash Even Salvini Compromised On Budget Clash Even Salvini Compromised On Budget Clash At present, the market is relieved that an election was avoided that might have seen Salvini and the League form a government with a much smaller right-wing party (Fratelli D’Italia) (Chart 6) – but the truth is that Salvini had already capitulated to the EU, both on budget matters and the euro currency. He was hardly likely to push for a budget more aggressive than that of the initial proposal in 2018. The clash with Brussels would have been a flash in the pan; the result would have been greater fiscal thrust, which would have been market-positive in the current environment. Chart 6Election Would Have Meant More Stimulus ... And More Political Risk Election Would Have Meant More Stimulus ... And More Political Risk Election Would Have Meant More Stimulus ... And More Political Risk M5S will also push for more spending and has also moderated their stance on the euro. A coalition with the Democrats will not work if the purpose is to push a euroskeptic agenda. There will be a focus on counter-cyclical fiscal policy, pragmatic reforms that the two can agree on, and fighting corruption. The budget talks will be a non-issue: the Democratic Party is an establishment party and the coalition will cooperate with Brussels. Furthermore, the context has changed since 2018 in a way that will reduce budget frictions. There is a need for countercyclical fiscal policy in light of the global slowdown, so the European Commission will have to be more flexible on the budget. This is particularly true if Germany itself loosens its belt on a cyclical basis. The risk to the above is that the coalition shaping up between the Democrats and Five Star is an alliance of convenience that will break down over time. Five Star will remain hard-line on immigration, which is driving anti-establishment sentiment. Italian elections are a frequent affair. Salvini and the League will be waiting in the wings, especially if Brussels proves too tight-fisted or if the Democrats do not toughen their stance on immigration. But as outlined above, Salvini’s own evolution on the euro, on northern Italy, and on the budget and financial stability shows that the economy will have to get a lot worse before Italian euroskepticism presents a renewed systemic risk. Bottom Line: The tentative coalition taking shape in Italy will produce a modest increase in fiscal thrust with minimal frictions with Brussels. As such it is the most market-friendly outcome that could have occurred from Salvini’s push to seize power. Beneath this episode of government change is the political arrangement taking shape in Italy, and across Europe, which calls for a commitment to the European project and currency. The price of this commitment is a tougher line on immigration from European leaders. Germany: Fiscal Loosening, But Not For The States (Yet) Our GeoRisk indicator for Germany is pointing to an increase in risk in recent weeks. Germany is threatened by a potential technical recession and while fiscal stimulus is in preparation, there will not be a fiscal game-changer until Merkel steps down in 2021 – barring a total collapse in the economy that forces her hand in the meantime. The outlook is not improving (Chart 7, top panel). The economy shrank by 0.1% in Q2 2019, exports are falling, and passenger car production is at the lowest level ever recorded (Chart 7, bottom panels). Chart 7German Economy Gets Pummeled German Economy Gets Pummeled German Economy Gets Pummeled Chart 8Germany: Expect Orthodox Stimulus For Now Germany: Expect Orthodox Stimulus For Now Germany: Expect Orthodox Stimulus For Now Finance Minister Olaf Scholz has announced that Germany could increase government spending by $55 billion within the context of European and German budget constraints. Split proportionally between 2019 and 2020, this additional spending would not put Germany in violation of the “black zero” rule – a commitment to a balanced budget that limits the federal structural deficit to 0.35% of GDP – even without any additional revenue (Chart 8).   There will not be a fiscal game-changer in Germany until Merkel steps down – barring a crisis. The German Chancellery reports that it does not see the need for stimulus in the short term – as long as trade tensions do not escalate and there is no hard Brexit. At present, however, trade tensions are escalating and the odds of a no-deal Brexit are increasing. Moreover China’s economy and stimulus efforts continue to disappoint. In this context Germany’s ruling coalition is putting together a climate change package that would entail additional spending (while stealing some thunder from the increasingly popular Green Party). Given the European Commission’s forecast of Germany’s 2020 budget surplus, 0.8% of GDP, the government could ultimately go further than Scholz’s ~$50bn. This is because the black zero rule provides for exceptions in case of recession (or natural disasters or other crises out of governmental control) with a majority vote in the Bundestag. Hence we are not so much concerned about the magnitude of the stimulus as its timing. First, Merkel and her coalition typically move slower than the market would like in the face of financial and economic challenges. Second, according to the black zero rule, which is transcribed in the German constitution (the Basic Law), the Länder cannot run budget deficits from 2020. Amending the constitution to delay this deadline requires a two-thirds majority in the Bundestag and the Bundesrat – a much taller order than the simple majority needed to boost federal deficits. The governing coalition currently holds 56% of the seats in the Bundestag. If the Greens were brought on board, which they would be inclined to do, this number falls just short of two-thirds at 65.6%. In order to obtain a two-thirds majority in the Bundesrat, the Social Democrats, Christian Democrats, and the Greens would need the support of another party, either the Left or the Free Democrats. This could be done but it would require political will, which is only likely to be sufficient if the German and global economy get worse from here. Meanwhile financial markets will have to settle for the gradual implementation of a stimulus package on the order of 1% of GDP – the one the government is planning. Bottom Line: While Germany will likely roll out a stimulus package by Q4, if third quarter GDP data confirm that the country is in a technical recession, Merkel’s hesitation and budget limits mean that this stimulus will likely be moderate. A marginal upside surprise is possible but it will not represent a true “game changer” on fiscal policy in Germany. The game changer is more likely after Merkel steps down in 2021. The Green Party is surging in Germany and could possibly lead the next government. Even if it doesn’t, its success and Europe-wide developments are pushing German leaders to become more accommodative. Brazil: Reform Or Bust Political turmoil in Brazil over the past five years has ultimately resulted in a right-wing populist government under President Jair Bolsonaro. Bolsonaro is pursuing a pension reform that is universally acknowledged as necessary to straighten out Brazil’s fiscal books, but that the previous government tried and failed to pass. On this front the news is market-positive: having cleared the lower Chamber of Deputies, the pension reforms are now likely to pass the senate. This will lift investor confidence and give Bolsonaro an initial success that he may then be able to translate into additional economic reforms. The Brazilian economy and financial markets are moving in opposite directions. The currency and equities staged a mid-year rally despite negative data releases – shrinking retail sales and industrial production amid high unemployment (Chart 9). More recently these assets relapsed despite tentative signs of improvement on the economic front (Chart 10). All the while, chaos and controversies surrounding Bolsonaro’s government have weighed on his approval rating, ending the honeymoon period after election (Chart 11). Chart 9Brazil: Signs Of Improvement Brazil: Signs Of Improvement Brazil: Signs Of Improvement   Chart 10Brazil: Markets Sold Despite Pension Progress Brazil: Markets Sold Despite Pension Progress Brazil: Markets Sold Despite Pension Progress Chart 11Bolsonaro’s Honeymoon Is Long Gone Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 The mid-year equity re-rating was driven by an improvement in sentiment on the back of the government’s pension reform. The relapse occurred despite the passage of the pension reform bill in the lower house, indicating that global economic pessimism has dominated. The bill’s next step goes to the senate where it faces two rounds of voting before enactment (Diagram 2). It should clear this hurdle by a large margin, though we expect delays. Diagram 2Brazil: Pension Reform Timeline Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 In the second round vote in the lower house on August 6 – which had a smaller margin of victory than the first round – deputies voted largely in line with party alliances (Charts 12A & 12B). Assuming legislators in the senate behave in the same way, the reform should gain the support of 64 of the 81 senators – easily surpassing the 49 votes needed. Even in a more pessimistic scenario where all opposition parties and all independent parties vote against the bill – along with two defecting senators from government-allied parties – the reform would pass by 56-25. Chart 12APension Bill Sailed Through Lower House ... Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Chart 12B... And Should Pass Senate In Time Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 This favorable outlook is also supported by popular opinion, which indicates that the majority of those polled agree that pension reforms are necessary (Chart 13). This leaves two questions: How soon will the bill clear the senate? According to senate party leaders’ proposed timetable, the bill will undergo its first upper house vote on September 18 with the second round slated for October 2. This is ambitious. The strategy of Senator Tasso Jereissati – who has been appointed senate pension reform rapporteur – is to approve the text in its current form and create a parallel proposed amendment to the constitution (PEC) which will bring together the amendments that senators make to the original text. Dozens of amendments have been filed with the Commission on Constitution and Justice. These will prolong the enactment of the final bill and dilute its impact. We doubt the senate will let Jereissati have his way entirely and hence expect delays and dilution. Chart 13Brazil: Public Now Favors Pension Reform Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Chart 14Brazil: Pension Reform Not Enough Brazil: Pension Reform Not Enough Brazil: Pension Reform Not Enough How much savings will the bill generate? Will the reforms be sufficient to improve public debt dynamics in Brazil? The Independent Fiscal Institute of the senate estimates that the reform will generate BRL 744 billion of savings. This is significantly less than the BRL 1.2 trillion initially proposed, and lower than the BRL 860 billion that Economy Minister Paulo Guedes has indicated as the minimum fiscal savings required. Our Emerging Markets strategists argue that the bill falls short of what is needed. While the plan will reduce the fiscal deficit and slow debt accumulation, it will be insufficient to generate primary surpluses over the coming years (Chart 14).1 Moreover, estimated savings in the final bill will likely be further revised down as the bill undergoes more amendments in the senate. What comes after pension reform? The market has focused almost exclusively on this issue to the neglect of Bolsonaro’s wider economic reform agenda. The agenda includes privatization, trade liberalization, tax reforms, and deregulation. Here we are more skeptical. First, Bolsonaro will have spent a lot of political capital on pensions. Second, while the economy and unemployment are always important, they are not the foremost concern for Brazilians (Chart 15). Chart 15Bolsonaro Will Lose Political Capital After Pension Bill Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Third, the economic agenda is often at odds with Bolsonaro’s social, foreign, and environmental policies: The new Mercosur-European Union trade agreement and ongoing trade negotiations between Mercosur and Canada are positive developments. However the G7 summit in France highlighted that the deal with the EU is at risk due to dissatisfaction with Bolsonaro’s response to the Amazon fires. France and Ireland have threatened to withhold support of the ratification. With world leaders concerned about the political risks of trade liberalization, and with Trump having issued a license to foreign leaders for trade weaponization, an escalation of tensions between the Europeans and Bolsonaro could lead to punitive measures even beyond the delay to the Mercosur-EU deal. Brazil’s China problem: Bolsonaro has been cozying up to President Donald Trump while striking a more aggressive tone with China. This is a risky strategy as it may undermine Brazil’s economic interests. The country’s exports are much more leveraged to China than to the U.S. and have been benefitting on the back of the trade war as China substitutes away from the U.S. (Chart 16). The president’s planned trip to China in October reveals an attempt to mend ties after having accused China of dominating key Brazilian sectors during his election campaign. But it is not clear yet that Bolsonaro will stage a retreat. And if President Trump backtracks on his trade war in order to clinch a deal, Bolsonaro may have lost some goodwill with China without receiving the benefit of China’s substitution effects. Hence Bolsonaro will have to soften his approach to China to make progress on the trade aspect of the reform agenda. Chart 16Brazil: Time To Mend Ties With China Brazil: Time To Mend Ties With China Brazil: Time To Mend Ties With China Bottom Line: We expect the passage of a diluted pension reform bill that will slow the growth of public debt to some extent. However global headwinds are persisting. And any success on pensions should not be extrapolated to other items on the economic reform agenda. Bolsonaro’s trade liberalization faces difficulties on the surface. Other domestic reforms are even more difficult to achieve in the wake of painful pension cuts. Reforms that enjoy public support and do not require a complicated legislative process are the most likely to be implemented, but even then, legislation and implementation are likely to be long-in-coming in Brazil’s highly fractured congress. As a result we share the view with our Emerging Markets Strategy that the pension reform is a “buy the rumor, sell the news” phenomenon. Housekeeping We are booking gains on our long BCA global defense basket for a 17% gain since inception in October 2018. The underlying thesis for this trade remains strong and we will reinstitute it at an appropriate time, though likely on a relative basis to minimize headwinds to cyclical sectors. We are also finally throwing in the towel on our long rare earth / strategic metals equity trade. The logic behind the trade is intact but it was very poorly timed and the basket has depreciated 24% since inception.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see BCA Research’s Emerging Markets Strategy Weekly Report “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. France: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 U.K.: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Germany: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019   Italy: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Spain: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Russia: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019   Korea: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Taiwan: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Turkey: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Brazil: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 What's On The Geopolitical Radar? Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Geopolitical Calendar

Highlights The U.S.-Sino trade war is taking a dangerous turn, but the U.S. should avoid a recession until 2022. Global growth will bottom in early 2020. The Fed is set to cut rates two to three times in the next year. Safe-haven bonds have more tactical upside, but will perform poorly on a cyclical basis. Long-term investors should use the next six to nine months to offload their corporate bonds. Equities will be volatile for the rest of 2019; a breakout is forecast for 2020. Long-term investors should favor stocks over bonds, and international stocks over U.S. ones. Feature The yield curve has become the punch line of late-night shows, triggered by the 2-/10-year yield curve inversion in early August. Recession fears have hit the front page. There are good reasons for the mounting concern. Historically, yield curve inversions have done an excellent job forecasting recession. The trade war between the U.S. and China is intensifying at an alarming speed. Moreover, global government bond yields are dipping to all-time lows. Additionally, the global ZEW and PMIs are depressed, while the global production of capital goods and machinery is contracting (Chart I-1). Despite this backdrop, the odds of a U.S. recession are overstated. Consumers in the U.S. and other advanced economies are healthy, the U.S. Federal Reserve and other major central banks are easing, and global financial conditions are supporting growth. We expect stocks to break out of their volatile period of consolidation early next year. Bond yields should rise later this year, but it is too early to stand in front of their downward trend. Finally, long-term investors should use any additional narrowing in credit spreads to lighten their exposure to corporates. U.S. Recession Odds Are Low The yield curve signal is not as dire as the headlines suggest. The inversion is incomplete; the curve is inverted up to the five-year mark and beyond that point, it steepens again. If the yield curve foreshadows a recession, then its slope would be negative across all maturities (Chart I-2). Chart I-1The List Of Worries Is Long The List Of Worries Is Long The List Of Worries Is Long Chart I-2   The consumer sector is doing well despite the global growth slowdown. Real retail sales, excluding motor vehicles, are growing at 4.4% and have quickly recovered from this past winter’s government shutdown. Meanwhile, retailers such as Walmart, Target, Home Depot and Lowe’s are reporting strong numbers. Three factors insulate consumer spending from global woes. First, household disposable income is expanding at a healthy 4.7% pace, courtesy of a tight labor market. Secondly, household balance sheets are robust. Household debt-servicing costs only represent 9.9% of disposable income, the lowest reading in more than four decades (Chart I-3, first panel). According to a December BIS paper, debt-servicing costs are one of the best forecasters of recessions.1 Additionally, household debt relative to GDP and to household assets is at 16- and 34-year lows, respectively (Chart I-3, second and third panel). Thirdly, the U.S. savings rate, which stands at 8.1%, already offers a cushion against adverse shocks and has limited upside. The corporate sector also displays some easily overlooked positives. So far, the PMIs and capex growth are still in mid-cycle slowdown territory. Meanwhile, debt loads have never provided an accurate recessionary signal. Since the end of the gold standard, recessions have always materialized after debt-servicing costs as a share of EBITDA rose two to four percentage points above their five-year moving average. We are nowhere near there (Chart I-4). Chart I-3Consumer Balance Sheets Are Very Robust Consumer Balance Sheets Are Very Robust Consumer Balance Sheets Are Very Robust Chart I-4Corporate Debt Is Not In Recessionary Territory Corporate Debt Is Not In Recessionary Territory Corporate Debt Is Not In Recessionary Territory   Nevertheless, we will remain vigilant on the capex trend. Corporate investment may not indicate a recession, but the escalating trade war with China will hurt capex intentions. Even if capex contracts, as in 2016, the economy can still avoid a recession. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. Housing is showing some positive signs after subtracting from GDP in the past six quarters. The NAHB Housing Market Index is recovering smartly from its plunge last year and homebuilder stocks have been outperforming the S&P 500 since October 2018 (Chart I-5). Meanwhile, the 139-basis point collapse in mortgage rates since November 2018 is finally impacting the economy. Mortgage demand is surging, according to the Fed’s Senior Loan Officers Survey. The MBA mortgage applications data corroborate this observation. As a result, both existing home sales and residential investment are trying to bottom (Chart I-6). Chart I-5Leading Indicators Of Residential Activity Are Improving Leading Indicators Of Residential Activity Are Improving Leading Indicators Of Residential Activity Are Improving Chart I-6Positive Signs For Residential Activity Positive Signs For Residential Activity Positive Signs For Residential Activity     The liquidity of the U.S. private sector is also strengthening. Deposit growth has reaccelerated after falling to near recessionary levels (Chart I-7) and the non-financial, private sector’s cash holdings are again increasing faster than debt. Furthermore, bank credit is expanding. Chart I-7The Private Sector Is Accumulating Liquidity The Private Sector Is Accumulating Liquidity The Private Sector Is Accumulating Liquidity Waiting For The Global Economy To Bottom Global growth should bottom by early 2020. Thus, while the U.S. economy should avoid a recession, any distinct re-acceleration will wait until next year. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. The trade war between the U.S. and China is intensifying. Chinese activity has not yet bottomed but policymakers will be increasingly forced to react. However, the global inventory down cycle is advanced, and in Europe, domestic activity indicators are holding up despite the continued deterioration in external and industrial conditions. Trade War The uncertainty created by the Sino-U.S. trade war is hurting global growth. On August 1, U.S. President Donald Trump announced a 10% tariff on the remaining $300 billion of Chinese exports to the U.S. The tariffs are phased in: $112 billions of goods will be taxed on September 1 while $160 billion will be hit on December 15. Unsurprisingly, a vicious circle of retaliation has been unleashed as China imposed a tariff ranging from 5% to 10% on U.S. goods last Friday, to which Trump immediately responded with a tariff hike from 25% to 30% on the $250 billion batch of goods and from 10% to 15% on the $300 billion batch slated to come into place September 1 and December 1. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. A resumption in talks between Beijing and Washington in September will offer little solace to investors. Even if President Trump is pressured by the stock market and the U.S. electoral calendar to settle for what Beijing is offering, it is not clear that President Xi Jinping will accept a deal. As BCA’s Chief Geopolitical Strategist Matt Gertken discusses in Section II, the two superpowers are locked in a multi-decade geopolitical rivalry and the Hong Kong protests and tensions over Taiwan could move the talks off track. China’s Challenges China’s economy has yet to bottom convincingly. So far, Chinese reflation has been weaker than anticipated. Given that stimulus has not been forceful, the uncertainty produced by the trade war and the illiquidity created by bloated balance sheets is still dragging down China’s marginal propensity to consume (Chart I-8). However, this propensity to spend has little downside, if the past 10 years are any indication. Chinese infrastructure and equipment investment needs to be revived. They are shouldering the bulk of the decline in economic activity and have slowed to an annual pace of 2.8% and -2.1%, respectively. Residential investment is expanding at a 9.4% annual rate (Chart I-9), but according to Arthur Budaghyan, BCA’s Chief Emerging Markets Strategist, even this sector’s strength could be an illusion. Chinese property developers are starting projects to raise funds via pre-sales. However, they are not completing nearly as many projects as they have started.2 Chart I-8A Falling Marginal Propensity To Spend Means More Stimulus Is Needed A Falling Marginal Propensity To Spend Means More Stimulus Is Needed A Falling Marginal Propensity To Spend Means More Stimulus Is Needed Chart I-9   We are not yet ready to give up on Chinese stimulus as the economy is on the verge of a deflationary spiral that could push debt-to-GDP abruptly higher. The following developments support this view: The statement following the July Politburo meeting showed a greater willingness to stimulate economic activity, as long as it does not add to the property bubble. Producer prices are again deflating. Contracting PPIs often unleash vicious circles as they push real rates higher and hurt investment, which foments additional price declines. Retail sales are slowing and the employment components of the manufacturing and non-manufacturing PMIs have fallen to 47.1 and 48.7, respectively. China’s economy needs to be insulated from the intensifying trade war with the U.S. or the deteriorating labor market will dampen consumer spending even more. We expect more tax cuts, more credit growth, and more issuance of local government special bonds to finance government spending, following China’s 70th anniversary celebrations on October 1. As Chart I-10 illustrates, an acceleration in total social financing will ultimately lift EM PMIs as well as Asian and European exports. Inventory Cycle The inventory cycle is very advanced. Inventories in the U.S., China and euro area are depleting (Chart I-11). Inventories cannot fall forever, especially when global monetary policy is increasingly accommodative and fiscal policy is loosened. Chart I-10More Chinese Stimulus Will Eventually Support Global Growth More Chinese Stimulus Will Eventually Support Global Growth More Chinese Stimulus Will Eventually Support Global Growth Chart I-11The Inventory Purge Is Advanced The Inventory Purge Is Advanced The Inventory Purge Is Advanced   Global activity can rebound if the inventory adjustment ends. Inventory fluctuations help drive the Kitchin cycle, a 36-40 month oscillation in activity. According to BCA’s Chief Global Strategist, Peter Berezin, the current slowdown is nearing 18 months, the typical length of a down oscillation in these cycles (Chart I-12).3 Europe     The manufacturing-heavy euro area will benefit when the global industrial cycle bottoms, but domestic tailwinds are also emerging. European deposits accumulation is quickening, driven by households (Chart I-13, top panel). Meanwhile, the European credit impulse has recovered thanks to the fall in both non-performing loans and borrowing costs (Chart I-13, bottom panel). Moreover, consumer spending is healthy as household balance sheets are improving and wage growth is accelerating to a 3.2% annual pace. Finally, last month we highlighted that the euro area fiscal thrust is set to increase by 0.7% of GDP this year.4 Fiscal easing appears set to expand as Germany and Italy study support packages. Finally, the Italian political uncertainty is receding as the Five Star Movement and the Democratic Party have agreed to form a coalition government. Chart I-12The Three-Year Cycle Is Also Advanced The Three-Year Cycle Is Also Advanced The Three-Year Cycle Is Also Advanced Chart I-13Some Ignored Improvements In Europe Some Ignored Improvements In Europe Some Ignored Improvements In Europe   At the moment, the biggest risk for Europe is the significant probability of a No-Deal Brexit. After the recent decision to prorogue Parliament, Matt Gertken raised his probability of a No-Deal Brexit to one third from 20%.Such an event would negatively impact Dutch, German and French exports, which could scuttle any improvement in Europe. Adding It Up The combined effects of more Chinese stimulus in the fourth quarter, an impending end to the global inventory drawdown, and an endogenous improvement in Europe, all should ultimately outweigh the negatives created by the U.S.-Sino trade war. Moreover, global financial conditions are easing (Chart I-14). Therefore, the fall in global bond yields should push the G-10 12-month credit impulse higher (Chart I-14, bottom panel). Lower oil prices should also help G-10 consumers. Early indicators support this assessment. BCA’s Global Leading Economic Indicator has been slowly bottoming, and according to its diffusion index, it will soon move higher (Chart I-15, top panel). Moreover, Singapore’s container throughput is tentatively stabilizing, while our Asian EM Diffusion Index is improving, albeit from depressed levels (Chart I-15, second panel). Finally, ethylene and propylene prices are rallying with accelerating momentum (Chart I-15, third and fourth panels). Chart I-14Easier Financial Conditions Favor Credit Growth Easier Financial Conditions Favor Credit Growth Easier Financial Conditions Favor Credit Growth Chart I-15Some Growth Indicators Are Stabilizing Some Growth Indicators Are Stabilizing Some Growth Indicators Are Stabilizing   Bottom Line: The U.S. economy will probably slow further in the coming months, but it will not enter into recession anytime soon. Neither debt nor consumers pose problems, the housing sector is turning the corner and the private sector’s liquidity position is strengthening. Meanwhile, global activity is trying to bottom, but any improvement will be delayed by the latest round of trade tensions. However, global policymakers are responding, thus global growth should improve by early 2020. Fed Policy: More Cuts Expected Chart I-16A Liquidity Crunch In The Interbank Market? A Liquidity Crunch In The Interbank Market? A Liquidity Crunch In The Interbank Market? Our base case is that the Fed will cut rates twice more in the coming nine months. In the tails of the probability distribution, three supplementary cuts are more likely than only one additional cut. Paradoxically, liquidity considerations support our Fed view. A recurring theme in our research is the improvement in global liquidity indicators such as excess money, deposit growth and our financial liquidity index.5 However, these indicators are not able to boost growth because of an important technical consideration. What might be classified as excess reserves by the Fed may not be free reserves. Higher Supplementary Leverage Ratios under Basel III rules require commercial banks to hold greater levels of excess reserves to meet their mandatory Tier 1 capital ratios. Since the Fed’s balance sheet runoff results in falling excess reserves, the decline in reserves may have already created some illiquidity in the interbank system. Global central banks have been divesting from the T-bill market, which is worsening the decline in excess reserves. They have parked their short-term funds at the New York Fed’s Foreign Repurchase Agreement Pool (Foreign Repo Pool) which limits the availability of reserves in the banking system (Chart I-16).6 These dynamics increase the cost of hedging the dollar for foreign buyers of U.S. assets. When reserves fall below thresholds implied by Basel III regulations, global banks lose their ability to use their balance sheets to conduct capital market transactions. Without this necessary wiggle room, they cannot arbitrage away wider cross-currency basis swap spreads and deviations of FX forward prices from covered interest rate parity. For foreign investors, the cost of hedging their FX exposure increases. Together with the flatness of the U.S. yield curve, hedged U.S. Treasurys currently yield less than German Bunds or JGBs (Table I-1). Chart I- Chart I-17Declining Excess Reserves Hurt Risk Assets And Growth Declining Excess Reserves Hurt Risk Assets And Growth Declining Excess Reserves Hurt Risk Assets And Growth Lower excess reserves and higher hedging costs have been bullish for the USD and negative for the global economy. Instead of buying hedged Treasurys, foreigners purchase U.S. assets unhedged (agency and corporate bonds, not Treasurys). Thus, falling excess reserves have been correlated with a stronger dollar, softer global growth and weaker EM asset and FX prices (Chart I-17). This adverse environment has accentuated the downside in Treasury yields and flattened the yield curve (Chart I-17, bottom panel). Going forward, these problems should intensify. The Treasury will issue over US$800 billion of debt by year-end to replenish its cash balance and finance the bulging U.S. budget deficit. Primary dealers will continue to plug the void left by foreigners and will purchase the expanding issuance (Chart I-18). In the past year, primary dealers have already increased their repo-market borrowing by $300 billion to finance their inventories of securities. They will need to expand these borrowings, which will further lift the cost of hedging U.S. assets. Thus, foreign investors faced with $16 trillion of assets with negative yields will buy more U.S. assets on an unhedged basis. The dollar will rise and global growth conditions will deteriorate. The Fed will have to cut rates two to three more times, otherwise the dangerous feedback loop described above will take hold. These cuts are more than domestic economic conditions warrant. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. The end of the balance sheet runoff is a step in the right direction, but it will not be enough. The BCA Financial Stress Index and our Fed Monitor are consistent with this view (Chart I-19). Moreover, the intensifying trade war is hurting the outlook for growth, inflation expectations and the stock market. Chart I-18A Large Inventory Build Up By Primary Dealers A Large Inventory Build Up By Primary Dealers A Large Inventory Build Up By Primary Dealers Chart I-19Two To Three More Cuts Are Coming Two To Three More Cuts Are Coming Two To Three More Cuts Are Coming   Investment Implications Government Bonds We have revised our position on an imminent end to the bull market. We do expect bond yields to be higher in 12 months, but for now the global economy has too many risks to time a bottom in yields. The cyclical picture for bonds is bearish. Treasurys have outperformed cash by 8% in the past year, a performance normally associated with a fed fund rate that is 200 to 300 basis points below what markets anticipated 12 months ago (Chart I-20). In order for Treasurys to continue outperforming cash, the Fed must cut rates to zero next year. Nonetheless, a U.S. recession is not in the offing and the global economy should perk up by early 2020. At most, the Fed will validate current rate expectations of 96 basis points of cuts. Chart I-20The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year Valuations are also consistent with Treasurys delivering negative returns in the next 12 months. According to the BCA Bond Valuation Index, Treasurys are extremely overvalued. Moreover, real 10-year yields are two standard deviations below the three-year moving average of real GDP growth, a proxy for potential GDP (Chart I-21). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. Technicals also point to poor 12-month prospective returns. The 13-week and 52-week rates of change in yields are consistent with tops in bond prices (Chart I-22). Positioning is also very stretched, as highlighted by the J.P. Morgan Duration Survey, the Bank of America Merrill Lynch Investors Survey, ETF flows, and government bonds futures and options holdings of asset managers. As a result, our Composite Technical Indicator is very overbought (Chart I-22, bottom panel). Chart I-21U.S. Bonds Are Very Expensive ... U.S. Bonds Are Very Expensive ... U.S. Bonds Are Very Expensive ... Chart I-22... And Very Overbought ... And Very Overbought ... And Very Overbought   The quickening pace of accumulation of securities on bank balance sheets also points to higher yields in 12 months (Chart I-23). As banks stockpile liquid assets, they accumulate more juice to fuel future lending. However, the rising cost of hedging FX exposure is bullish for the dollar. Hence, increasing Treasury holdings will not lift yields until the Fed cuts rates more aggressively. We are reluctant to recommend shorting / underweighting bonds. As Chart I-24 illustrates, mounting uncertainty over economic policy anchors U.S. yields. Last week’s round of tariff increases, along with the Brexit saga, suggests that the uncertainty has not yet peaked. Chart I-23A Coiled Spring A Coiled Spring A Coiled Spring Chart I-24Uncertainty Is Keeping Global Bonds Expensive Uncertainty Is Keeping Global Bonds Expensive Uncertainty Is Keeping Global Bonds Expensive   The collapse in German yields is also not finished. The fall in bund yields to -0.7% has dragged down rates worldwide as investors seek positive long-term returns. In response, the U.S. 10-year premium dropped to -1.1%. Historically, bunds end their rally when yields decline 120 basis points below their two-year moving average (Chart I-25). If history is a guide, German yields could bottom toward -1%, which is in line with Swiss 10-year yields. The 1995 experience also argues against an imminent end to the bond rally. In a recent Special Report, BCA’s U.S. Equity Strategy service highlighted the parallels between today’s environment and the aftermath of the December 1994 Tequila Crisis.7 In that episode, global growth troughed and the Fed cut rates three times before the U.S. ISM Manufacturing Index bottomed in January 1996. Only then did Treasury yields turn higher (Chart I-26). A similar scenario could easily unfold. Chart I-25More Downside For German Yields More Downside For German Yields More Downside For German Yields Chart I-26Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More   EM assets are vulnerable and could spark a last stampede into U.S. Treasurys. Investors of EM fixed-income products have not yet capitulated. EM assets perform poorly when global growth is weak, dollar funding is hard to come by and trade uncertainty is rising. Yet, yields on EM local-currency bonds have fallen, indicating little selling pressure. Rather than dispose of their EM holdings, investors have hedged their EM exposure by selling EM currencies. Therefore, EM bonds are rallying with EM currencies falling (Chart I-27), which is a rare occurrence. Recent cracks in EM high-yield bonds and the breakdown in EM currencies suggest investors will not ignore the trade war for much longer. The ensuing flight to safety should pull down Treasury yields. Chart I-27A Rare Occurrence A Rare Occurrence A Rare Occurrence BCA’s Cyclical Bond Indicator has yet to flash a buy signal, which will only happen when the indicator moves above its 9-month moving average (Chart I-28). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. As a corollary, we remain positive on gold prices and expect the yellow metal to move to $1,600 in the coming months. Chart I-28BCA Cyclical Bond Indicator: Don't Sell Yet BCA Cyclical Bond Indicator: Don't Sell Yet BCA Cyclical Bond Indicator: Don't Sell Yet Corporate Bonds Chart I-29Corporate Bond Fundamentals Are Worsening Corporate Bond Fundamentals Are Worsening Corporate Bond Fundamentals Are Worsening The long-term outlook for corporate bonds is deteriorating enough that long-term investors should use any rally to lighten their exposures. However, on a six- to nine-month horizon, stresses will probably remain contained. A significant deterioration in corporate health will hurt this asset class’s long-term returns. Recent data revisions pushed GDP and productivity well below previous estimates. This curtailed corporate profitability, lifted debt-to-cash flow ratios, and hurt interest coverage measures. BCA’s Corporate Health Monitor is flashing its worst reading since the financial crisis. Moreover, the return on capital is at its lowest level in this cycle. Historically, these developments have pointed to higher default rates and spreads (Chart I-29). Worryingly, average interest coverage and profitability levels are distorted. Tech firms only account for 8% of the U.S. corporate bond universe, yet they represent 19% of cash flows generated by the U.S. corporate sector. Outside the tech sector, cash generation is poorer than suggested by our Corporate Health Monitor. This will amplify losses when the default cycle begins. The poor quality of bond issuance in the past 8 years will also hurt recovery rates when defaults rise. Since then, junk bonds constitute 10% of overall issuance, and BBB-rated bonds represent 42% of investment-grade issues. Historical averages are 9% and 27%, respectively. Additionally, covenants have been particularly light in the same period. Investors with horizons of one year or less still have a window to own corporate bonds. Moreover, since the deviation of corporate debt-servicing costs as a percentage of EBITDA remains well below historical trigger points, an imminent and durable jump in spreads is unlikely. Within the corporate universe, BCA’s U.S. Bond Strategy service currently favors high-yield to investment-grade bonds.8 Breakeven spreads in the junk space are much more rewarding than those offered by investment-grade issues (Chart I-30). Equities We expect the S&P 500 to remain volatile and below 3,000 for the rest of 2019. Early next year, an upside breakout will end this period of churn. The S&P will probably soon test the 2,700 level. Technically, the selling is not exhausted. The number of stocks above their 40-, 30- and 10-week moving averages have formed successively lower highs and are not yet oversold (Chart I-31). Furthermore, the Fed is unlikely to deliver a dovish surprise in September. Fed Chairman Jerome Powell’s recent speech at Jackson Hole suggests that the Fed needs to see more pain before moving ahead of the curve. Chart I-30Short-Term Investors Should Favor Junk Over Investment Grade Issues Short-Term Investors Should Favor Junk Over Investment Grade Issues Short-Term Investors Should Favor Junk Over Investment Grade Issues Chart I-31This Correction Can Run Further This Correction Can Run Further This Correction Can Run Further   Once stocks stabilize, the subsequent rebound will not lead to an immediate breakout this year. Yields will move up when growth picks up or if President Trump becomes less combative on trade. However, falling interest rates have been a crucial support for stock prices in 2019. As the 1995-1996 experience shows, when the ISM turned up, the S&P 500 did not gain much traction. Higher yields pushed down multiples even as earnings estimates strengthened. We are more positive on the outlook for stocks next year with BCA’s Monetary Indicator pointing to higher stock prices (see Section III). Moreover, bear markets materialize only when a recession is roughly six to nine months away (Chart I-32). The S&P still has time to rally because we do not anticipate a recession until early 2022. Chart I-32No Recession, No Bear Market No Recession, No Bear Market No Recession, No Bear Market Chart I-33Better Prospects For Non-U.S. Stocks Better Prospects For Non-U.S. Stocks Better Prospects For Non-U.S. Stocks Cyclical investors should move their equity holdings outside the U.S. International markets are comparatively cheap (Chart I-33, top panel). Moreover, a rebound in global growth early next year is congruent with U.S. underperformance. Finally, our earnings models forecast an end to the deterioration of European profit growth in September 2019, but not yet in the U.S. (Chart I-33, bottom two panels). Stocks should outperform bonds on a long-term basis. According to the BCA Valuation Index, U.S. stocks are extremely expensive (see Section III). Our valuation indicator would be as elevated as in 2000 if interest rates were not so depressed today. As Peter Berezin showed in BCA’s Global Investment Strategy service, based on current valuation levels, investors can expect 10-year returns of 3.0%, 4.5%, 11.9% and 7.4% for the U.S., euro area, Japan and EM equities, respectively.9 This is not appealing. Nonetheless, long-term equity expected returns are superior to bonds. If held to maturity, they will return 1.5%, -0.7%, and -0.3% annually in the U.S., Germany and Japan, respectively. Practically, long-term investors should favor the rest of the world over the U.S. Local-currency expected returns are higher outside the U.S., and the dollar will decline during the next 10 years. As our Foreign Exchange Strategy service recently highlighted, the dollar is very expensive on a long-term basis.10 Exchange rates strongly revert to their purchasing-parity equilibria in such investment horizons. The growing U.S. twin deficit and the strong desire of reserve managers to diversify out of the greenback will only exacerbate the dollar’s decline. Mathieu Savary Vice President The Bank Credit Analyst August 29, 2019 Next Report: September 26, 2019   II. Big Trouble In Greater China The chance of a U.S.-China trade agreement by November 2020 is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities.   “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart II-1). Chart II-1Trump's Latest Tariff Salvo Trump's Latest Tariff Salvo Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. Chart II-2 The same pattern played out on August 23 when President Trump responded to China’s retaliatory tariffs by declaring he would raise tariffs to 30% on the first half of imports and 15% on the remainder by December 15. Within a single weekend he softened his rhetoric and said he still wanted a deal. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart II-2) – an actual recession would consign him to history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart II-3). This leaves him less room for maneuver going forward. The fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart II-4). Chart II-3China's Gradual Stimulus Yet To Revive Global Economy China's Gradual Stimulus Yet To Revive Global Economy China's Gradual Stimulus Yet To Revive Global Economy Chart II-4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus   The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart II-5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart II-6). Chart II-5Trump Fears Growing Talk Of Recession Trump Fears Growing Talk Of Recession Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart II-7). Chart II-6 Chart II-7Trump's Fiscal Policy Undid His Trade Policy Trump's Fiscal Policy Undid His Trade Policy Trump's Fiscal Policy Undid His Trade Policy   The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop (Chart II-8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart II-8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not yet closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.11 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,12 and will the outcome derail the trade talks? The biggest question in the trade talks is no longer Trump, but Xi. Bottom Line: Global economic growth is fragile and President Trump has only rhetorically retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table II-1). Many of these concessions have been postponed as a result of Trump’s punitive measures. Chart II- It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. Chart II-9China's Ultimate Economic Constraint China's Ultimate Economic Constraint China's Ultimate Economic Constraint China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “respect” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point, mutual respect, is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart II-9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has largely been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart II-10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. Chart II-10Creative Destruction In China Creative Destruction In China Creative Destruction In China These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart II-11China's Vast Market Its Most Persuasive Tool China's Vast Market Its Most Persuasive Tool China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart II-11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, and the  extent of tariff rollback which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram II-1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Chart II- Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart II-12A & II-12B). Chart II-12 Chart II-12   Chart II-13 A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart II-13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing rotating troops into the city and openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart II-14U.S. Approves Big New Arms Sale To Taiwan U.S. Approves Big New Arms Sale To Taiwan U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart II-14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. Chart II-15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart II-15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart II-16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart II-17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart II-18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature. Chart II-16 Chart II-17   Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart II-19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time. Chart II-18 Chart II-19   While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart II-20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart II-21). Chart II-20 Chart II-21   This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart II-22). A deterioration in this region has global consequences. Chart II-22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward.  Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken Vice President Geopolitical Strategy   III. Indicators And Reference Charts The S&P 500 correction is likely to deepen a bit further. A move toward 2700 remains our base case scenario. Short-term oscillators have not yet reached capitulation levels and the Sino-U.S. trade war remains a source of risks, especially as the Chinese side is unlikely to provide any strong concessions until October. However, we still do not expect a deeper correction to unfold. In other words, equities remain stuck in a trading range for the remainder of the year. 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. Beyond this year, the outlook remains constructive of 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. The WTP therefore argues that investors are still looking to buy the dips in the U.S. and in Japan, which limits the downside in those markets. Yields have collapsed, money growth has picked up, and global central banks are cutting rates in unison. As a result, our Monetary Indicator points to the most accommodative global monetary backdrop since early 2015. Moreover, our Composite Technical Indicator is improving and continues to flash a buy signal. In 2015, it was deteriorating after having hit overbought territory. Therefore, unlike four years ago, equities are more likely to avoid the gravitational pull created by their overvaluation, especially as our BCA Composite Valuation index is in fact improving thanks to lower bond yields.  According to our model, 10-year Treasurys have not been this expensive since late 2012. Back then, this level of overvaluation warned of an impending Treasury selloff. Moreover, our technical indicator is now deeply overbought. So are various rate-of-change measures for bond prices. While none of those indicators can tell you if yields will move up in the next few weeks, they do argue that the risk/reward of holding bonds over the coming year is extremely poor. That being said, we are closely monitoring the recent breakdown in the advanced/decline line of commodities, which might herald another down-leg in commodity prices, and therefore, in bond yields as well. On a PPP basis, the U.S. dollar is only growing ever more expensive. Additionally, despite the dollar’s recent strength, our Composite Technical Indicator has lost enough momentum that the negative divergence we flagged last month remains in place. It is worrisome for dollar bulls that despite growing uncertainty and a deteriorating global economy, the euro is not breaking down. If the dollar’s Technical Indicator deteriorates further and falls below zero, the momentum-continuation behavior of the greenback will likely kick in. The USD would suffer markedly were this to happen. 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       Claudio Borio , Mathias Drehmann, Dora Xia, "The financial cycle and recession risk," BIS Quarterly Review, December 2018. 2       Please see Emerging Markets Strategy Special Report "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, available at ems.bcaresearch.com 3       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com 4       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 5       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 6       For an explanation of the mechanics of the FRP, please see NY Fed’s website: https://www.newyorkfed.org/aboutthefed/fedpoint/fed20 7       Please see U.S. Equity Strategy Special Report "Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse," dated August 19, 2019, available at uses.bcaresearch.com 8       Please see U.S. Bond Strategy Weekly Report "The Trump Interruption," dated August 13, 2019, available at usbs.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Please see Foreign Exchange Strategy Special Report, “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 11     Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 12     Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: