Europe

Feature Feature ChartNo 'Secular Stagnation' In Japan! No Secular Stagnation In Japan! No Secular Stagnation In Japan! Bond yields have plummeted to all-time lows and inflation has continued to undershoot the 2 percent target which central bankers tell us is ‘price stability’. This configuration has led to renewed fears that the European and global economies are entering a so-called ‘secular stagnation’. We strongly disagree with this line of thinking. Near-zero bond yields and inflation are categorically not portents of a long-term drought in economic progress. Quite the opposite. Chart I-2Japan Has Experienced Near-Zero Inflation For Decades Japan Has Experienced Near-Zero Inflation For Decades Japan Has Experienced Near-Zero Inflation For Decades Japan has experienced near-zero bond yields and inflation for decades (Chart I-2). Yet since the late 1990s, the growth in Japan’s real GDP per head has outperformed every other major economy1 (Feature Chart). Granted, the Japanese government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements. The ability to learn, experiment, and innovate boosts the quality and/or quantity of output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements marks genuine and sustainable economic progress. In Europe, Switzerland tells a similar tale. Swiss bond yields and inflation have been near zero for decades, but they have not defined a secular stagnation. Real GDP per head and living standards have steadily advanced, even from an already high base. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements.  But the best counterexample comes from economic history. At the height of the British Empire in 1914, British consumer prices were little different to where they stood at the end of the English Civil War in 1651 – meaning that Britain experienced near-zero inflation and low bond yields for almost three centuries (Chart I-3). Did these define a secular stagnation? No, quite the opposite. For Britain, this was a golden epoch in which it emerged as the world’s preeminent economy. Chart I-3Britain Experienced Near-Zero Inflation For Centuries Britain Experienced Near-Zero Inflation For Centuries Britain Experienced Near-Zero Inflation For Centuries The Real Reason For Near-Zero Inflation And Bond Yields The fear-mongering about a secular stagnation misses the real reason for today’s sub-2 percent inflation and record low bond yields. Central banks have wrongly defined price stability. Central banks have wrongly defined price stability because they think of it in terms of the economics and mathematics in which they have expertise. Their models tell them that they can nail inflation to one decimal place – two point zero. But price stability has as much to do with biology and psychology. Biologists will tell you that the human brain cannot distinguish inflation rates between -1 and 2 percent, a range we indistinguishably perceive as ‘price stability’. If biology teaches us that we cannot distinguish between -1 and 2 percent inflation, then central banks have a huge problem. It is impossible for a central bank to change our inflation expectations within that range, because the entire range just feels the same to us. Therefore, our behaviour in terms of wage demands and willingness to borrow will also stay unchanged. And if our economic behaviour is unchanged, what is the transmission mechanism to fine tune inflation within the -1 to 2 percent range? Central banks have wrongly defined price stability.  Therefore, price stability is actually like a ‘quantum state’. You’re in the state or you’re out of the state, but once you’re in the state you cannot then fine tune inflation to an arbitrary number like two point zero. In fact, average inflation over, say, five years will gravitate to the mid-point of the price stability state, 0.5 percent, which is a long way below the central bank’s arbitrary target of 2 percent (Chart I-4). This forces the central bank into drastic and prolonged monetary policy easing – which depresses bond yields (Chart I-5). Chart I-4Central Banks Have Wrongly Defined Price Stability... Central Banks Have Wrongly Defined Price Stability... Central Banks Have Wrongly Defined Price Stability... Chart I-5...Forcing Them To Depress Bond Yields ...Forcing Them To Depress Bond Yields ...Forcing Them To Depress Bond Yields Monetary Policies Will Ultimately Converge As structural credit booms have sequentially ended, economies have one by one entered the state of price stability. First it was Japan; then it was Switzerland; more recently it has been the euro area and the United States. It follows that the 5-year annualised inflation rates have also sequentially tumbled to the mid-point of the price stability state, around 0.5 percent. By which point, inflation is so far below the misplaced 2 percent target, that the central bank’s drastic and prolonged monetary policy easing has depressed the 5-year bond yield to near zero. Japan reached this point in the late 1990s, Switzerland in the early 2010s, and the euro area in the late 2010s. Begging the question: why has the 5-year inflation rate in the U.S. not tumbled towards 0.5 percent too?  The answer is that actually, it has. On a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions. You see, the Americans measure inflation differently to the Europeans. In the U.S., the consumer price basket includes owner-occupied housing costs at a substantial weighting, while in Europe it is completely excluded. Using the same definition of inflation as in Europe, the U.S. 5-year inflation rate is not at 1.5 percent, it is at a feeble 0.6 percent (Chart I-6). Chart I-6On a Like-For-Like Basis, U.S. 5-Year Inflation Is A Feeble 0.6 Percent On a Like-For-Like Basis, U.S. 5-Year Inflation Is A Feeble 0.6 Percent On a Like-For-Like Basis, U.S. 5-Year Inflation Is A Feeble 0.6 Percent Crucially, on a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions: the U.S., euro area, and Japan. This leads us to believe that the current chasm in monetary policies is unsustainable. Even including owner-occupied housing in the consumer price basket, as the U.S. does, the long run boost to annual inflation is only about 0.2 percent (Chart I-7). Meaning that it is only a matter of time before U.S. structural inflation and bond yields converge with those in the euro area. Chart I-7Owner-Occupied Housing Boosts Inflation, But In The Long Run By Only 0.2 Percent Owner-Occupied Housing Boosts Inflation, But In The Long Run By Only 0.2 Percent Owner-Occupied Housing Boosts Inflation, But In The Long Run By Only 0.2 Percent In the meantime, the chasm between monetary policies 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 polarised monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart I-8). On this point, President Trump is spot on to complain that the Fed’s policy stance relative to other central banks is severely handicapping U.S. manufacturers. As the president tries to counter this handicap with tariffs, real or threatened, the Fed is being forced to lean against the risks to growth and inflation. Chart I-8Blame Polarised Monetary Policies For The Euro Area’s Huge Trade Surplus With The U.S. Blame Polarised Monetary Policies For The Euro Area's Huge Trade Surplus with the U.S. Blame Polarised Monetary Policies For The Euro Area's Huge Trade Surplus with the U.S. What Does All Of This Mean? One way or another, the dollar will come under structural pressure in the coming years as the current chasm in monetary policies proves to be unjustified. However, in the near term, we prefer to express this not via the euro, but via the yen. The corollary is that U.S bond yields will eventually converge with their European counterparts. But to reiterate, a world with near-zero inflation is categorically not a portent of secular stagnation. It is just the true state of price stability as the human brain perceives it, rather than the over-precise two point zero that central banks have arbitrarily picked. In turn, ultra-low bond yields stem from the monetary policy response to this massive undershoot of true price stability from central bank defined price stability.   All of this raises a fascinating question: if bond yields are lower than is truly required, why hasn’t it created a new inflation? The answer is that it has, but the new inflation is not in the real economy. The reason is that the world has just been through a structural credit boom, remains heavily indebted, and is still unwinding some of the credit excesses. In this world, as Japan has illustrated in recent decades, productivity growth must drive economic progress. Chart I-9 Instead, the new inflation is in equity and other risk-asset prices. At ultra-low bond yields the prospect of bond capital gains diminishes versus potential losses, making bonds as risky as equities. This removes the need for an excess return on equities and other risk-assets versus bonds, meaning that the valuation of risk-assets inflates exponentially (Chart I-9). So long as bond yields remain depressed, this new inflation in risk-asset valuations is well justified and supported.2  But be very careful if the global 10-year bond yield rises above 2 percent.3   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on real GDP per working age (15-64) population, but also broadly true for real GDP per total population. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25 2018, available at eis.bcaresearch.com. 3 The global 10-year bond yield is the simple average of 10-year government bond yields in the U.S., euro area (or France as a proxy), and China.

Dear Client, Please note that there will be no regular Weekly Report next week, as we take a summer break. Our regular publication will resume September 6th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights Our PPP models show the DXY index to be overvalued by 10-15%. Within the G10 universe, the cheapest currencies are the Swedish krona, the British pound, the Japanese yen and the Norwegian krone. Look to go short CHF/GBP on valuation grounds. Feature Regular readers of our publication will notice that we tend to adhere to very simple and time-tested ideas. One such is the concept of purchasing power parity (PPP). The beauty comes from its simplicity. If the price of a good in Sweden is rising faster than in South Africa, then the krona should depreciate versus the rand to equalize prices across both borders. Otherwise, the krona becomes incrementally expensive, relative to the rand. In practice, various models have shown PPP to be a very poor tool for managing currencies. One roadblock comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. Second, there is less price discovery for services, than there is for tradable goods. For example, it is rather difficult to import a haircut from Mumbai into the U.S., and so arbitraging those prices away tends to be impractical. Tariffs, trade restrictions and transport costs also tend to dampen the explanatory power of PPP models, though those have had diminishing importance over time. In order to get closer to an apples-to-apples comparison across countries, we make two adjustments. First, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: Food, restaurants and hotels Shelter Health, culture and recreation Energy and transportation Household goods The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If for example, shelter is 33% in the U.S. CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. The results were largely consistent: Both regressions were statistically significant, but more so for REG1. This makes intuitive sense, as the number of variables were higher in the first regression. The sign for household goods was negative for some countries. This could be due to some specter of multicollinearity, if the tradable goods price effect is captured in other categories. There is also the low value-to-weight ratio for many household goods such as refrigerators or air conditioners, which could make currency deviations from PPP persistent. The shelter sign was also negative for some countries, meaning rising shelter prices tended to be associated with an incrementally cheaper currency. This could be due to the Balassa-Samuelson effect. Rising incomes (one key determinant of rising house prices) usually reflect rising productivity levels, which tend to lift the fair value of the exchange rate. The results showed the U.S. dollar as overvalued, especially versus the Swedish krona, British pound and Norwegian krone. Commodity currencies were closer to fair value, and within the safe haven complex, the Japanese yen was more attractive than the Swiss franc. The euro was less undervalued than implied by the overvaluation in the DXY index. As a final note, PPP models are just an additional kit to our currency toolbox, and so should never be used in isolation, but in conjunction with other currency signals. This is just a first iteration in our PPP modelling work, which we intend to improve in the months to come. U.S. Dollar We reverse-engineered the fair value for the DXY index by aggregating the model results from its six constituents. This includes the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc, using the corresponding DXY weights. The message from the synthetic model is clear: the U.S dollar is above its fair value, in line with our fundamental view (Chart 1). Chart 1The Dollar is Slightly Expensive The Dollar is Slightly Expensive The Dollar is Slightly Expensive Americans spent 35% of their income in 2018 on goods and 65% on services. Shelter remains the single largest consumption item for American households, which makes up 33% of the consumption basket. However, the relative importance of shelter is dwarfed by much more rampant rent and house price increases in other developed countries. Medical care accounts for 8.7% of the CPI basket, and is the highest in the developed world on a per capita basis. Total spending on health care accounts for almost 20% of nominal GDP. Since the 1980s, the CPI for medical care has risen fivefold, far outpacing many developed countries. This makes the dollar incrementally expensive.  Core CPI edged higher to 2.2% in July, driven by medical care and shelter. While above the Federal Reserve’s 2% target, the risks to inflation remain asymmetric to the downside. That will keep the Fed on a dovish path near-term, which should help close overvaluation in the dollar. Euro We had limited data for the euro area, and so our regression results were less robust. REG1 shows the euro as cheap, while REG2 is more ambiguous (Chart 2). In short, a PPP model for the euro had one of lowest explanatory powers within the G10 universe. Food, restaurants and hotels are the largest consumption item in the euro CPI basket. Looking at the details, food and non-alcoholic beverages account for 14%, alcohol and tobacco make up 4%, and restaurant and hotels account for about 10% (Table). Relative price trends have moved to undermine the fair value of the euro. Chart 2The Euro Is Slightly Cheap The Euro Is Slightly Cheap The Euro Is Slightly Cheap Euro Area CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter’s weight in the euro area CPI basket currently stands at 16.7%, the smallest among G10 countries. Since 2012, relative house and rent prices in the euro area have been decreasing compared with that in the U.S. Rampant rent controls, especially in places like Germany have subdued housing CPI, and tempered the fair value of the euro. This makes sense to the extent that it represents a concomitant rise in the welfare state. It is well-known that the euro area is relatively open and so tradable goods prices are important for the fair value of the euro. Given that the epicenter of trade tensions is between the U.S. and China, this will act to boost the relative attractiveness of European goods, which will be a bullish underpinning for the euro. Inflation expectations have collapsed in the euro area. However, compared to the Federal Reserve, there is little the European Central Bank can do to boost inflation. This is relatively euro bullish. Once global growth eventually picks up, improved competitiveness in the periphery will allow for non-inflationary growth. Japanese Yen The yen benefits from being cheap, as well as being a safe-haven currency (Chart 3). The overarching theme for Japan is a falling (and rapidly aging) population, which means that deficient demand and falling prices are the norm. This makes the yen relatively attractive on a recurring basis. Most of the Heisei era in Japan has been characterized by deflation. Importantly, all categories in Japan have been in a relative price downtrend during this period (Table). Domestically, an aging population (that tends to be a large voting base), prefer falling prices. Meanwhile, the bursting of the asset bubble in the late 80s/early 90s led to a powerful deleveraging wave that undermined prices. Chart 3The Yen Is Quite Cheap The Yen Is Quite Cheap The Yen Is Quite Cheap Japan CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity The relative prices for most items have been decreasing, but culture and recreation inflation have experienced a meaningful rebound since 2013, largely due to a booming tourism industry in Japan.1 According to tourism statistics, the number of international visitors to Japan reached 31 million in 2018, almost five times the number ten years ago. But as long as the younger generation in Japan continues to save more and consume less, prices will remain under pressure. BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, but inflation expectations are falling to historical lows at a time when the BoJ is running out of policy bullets.2  That means inflation will likely lag that of other developed countries, lifting the fair value of the yen. British Pound Both regressions show the pound as undervalued. This supports our view that over the long term, the pound is a categorical buy (Chart 4). The consumption baskets in both the U.K. and the U.S. are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials (Table). For example, OECD PPP models, based on national expenditure, show the pound as 15% undervalued. Chart 4The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap U.K. CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Housing is the largest item in the consumption basket, with a total weight close to 30% (including housing electricity and water supply). The shelter consumer price index in the U.K. started to fall relative to the U.S. in 2016, which has lowered the fair-value of the pound (in the Balassa-Samuelson framework). That said, the fall in the pound has been much more deep and violent than suggested by domestic price fundamentals. For example, food restaurants and hotels are 10% cheaper in the U.K. compared to the U.S. over the last half decade. However, rather than appreciating 10%, the pound has plummeted by about 30%. Brexit will continue to dictate the ebb and flow of sterling gyrations, but the reality is that the pound should be higher on a fundamental basis. Meanwhile, a pick up in the global economy will benefit the pound. Going short CHF/GBP on valuation grounds is an attractive bet today. Australian Dollar As a commodity currency, PPP models are less useful for the Australian dollar than terms of trade, or even interest rate differentials. That said, the Aussie dollar is still relatively cheap versus the USD on a PPP basis (Chart 5). The key driver for value in the AUD has been a drop in the currency, relative to what price differentials will dictate. Food, restaurants and hotels comprise 23% of the Australian CPI basket, with the alcohol and tobacco category alone making up 7.4% (Table). Given food price differentials have been stable versus the U.S. in over a decade, Aussie citizens have not been particularly worse off. Chart 5The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap Australia CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter accounts for almost a quarter percent of the basket. Relative shelter prices in Australia have been rising since the late 1990s, but started to soften in the past few years, on the back of macro prudential measures. Meanwhile, holiday travel and accommodation have a total weight of 6%, of which domestic travel makes up 2.9%, and international travel 3.1%. The overall cost of tourism in Australia has been falling relative to the U.S., boosting the fair value of the Aussie. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, but more by RBA policy and terms of trade. New Zealand Dollar The New Zealand dollar is at fair value according to both models (Chart 6).  Like the aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have not been moving in favor of the kiwi (Table). So, while the kiwi was overvalued earlier this decade, the overvaluation gap has been mostly closed via a higher dollar. Chart 6The Kiwi Is At Fair Value The Kiwi Is At Fair Value The Kiwi Is At Fair Value New Zealand CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Relative shelter prices in New Zealand have been soaring in recent decades compared to the U.S. Higher immigration, foreign purchases and a commodity boom helped. However, in August 2018, the ban on foreign property purchases came into effect, which helped cool down the housing market. Like in Australia, the inflation rate in New Zealand reached 18% year-on-year in the early 1980s, and was subsequently addressed via inflation targeting. This has realigned New Zealand prices somewhat with the rest of the world. Our bias is that going forward, the kiwi will underperform the aussie, mainly because of a negative terms of trade shock. Canadian Dollar The loonie is currently trading below its fair value, according to both of our models (Chart 7).  Shelter remains the largest budget item for Canadian households (Table). The average Canadian household spent C$18,637 on shelter per year, around 29.2% of the total consumption in 2017.3 Interestingly, the shelter consumer price index does not fully capture skyrocketing house prices in Canada over the last decade. Since 2005, Canadian house prices relative to U.S. have doubled, according to OECD. On the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the explanatory power of the exchange rate. Chart 7The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap Canada CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Canadians are avid users of private transportation. The average spending on transportation accounted for 20% of total consumption, the second-largest expenditure item. Relative prices in this category have been rising, which has lowered the fair value of the exchange rate. Canada stands as the sixth largest energy producer in the world, but due to heavy taxation, Canadian consumers are paying more for gas prices than their U.S. neighbors. That said, terms of trade have been more important than PPP concerns for the loonie. In the near term, we believe energy prices (and the Western Canadian Select price spread) will continue to be important for the loonie. Swiss Franc USD/CHF is trading slightly below fair value, despite structural appreciation in the franc in recent years (Chart 8). The largest consumption item in Switzerland is the food, restaurants and hotels category (Table). The second item is shelter. Social services have a higher weight in the CPI basket, compared to other developed nations. This has been a huge driver of relative prices between Switzerland and the rest of the world, with falling relative prices boosting the fair value of the franc. Chart 8The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value Switzerland CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Healthcare notably accounts for 15.5% in the total CPI basket, of which patient services makes up 11.5%. The Swiss healthcare system is a combination of public, subsidized private, and entirely private systems. It is mandatory for a Swiss resident to purchase basic health insurance, which covers a range of treatments. The insured person then pays the insurance premium plus part of the treatment costs. Finally, as a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are soaring to record highs. This makes the franc a core holding in a currency portfolio. Norwegian Krone The Norwegian krone is undervalued according to both models (Chart 9). Food and shelter account for the largest share of the Norwegian CPI basket (Table). While the share of shelter is lower than in the U.S., other categories share similar weights, allowing traditional PPP models to be adequate for USD/NOK. One difference is that in terms of social services, only 0.2% of the expenditures are allocated to education, since all schools are free in Norway, including universities. Chart 9The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap Norway CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity As a large energy producer, Norwegians pay less for electricity, gas, and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices. Going forward, the path of energy prices will continue to dictate ebbs and flows in the krone. Meanwhile, long NOK positions also benefit from an attractive valuation starting point.  Swedish Krona The krona is the cheapest currency in our universe by a wide margin (Chart 10). This stems less from fluctuations in relative prices and more from negative rates that have hammered the exchange rate. Like many countries, food and shelter is the largest component of the consumption basket (Table). Transportation is also important. However, an important driver for undervaluation in the currency has been a drop in the relative price of social services. Chart 10The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap Sweden CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Sweden experienced very high inflation rates in the 1980s, and since then, has been in a disinflationary regime. More recently, the inflation rate has edged down below the Riksbank’s target, mostly dragged down by recreation, culture, and healthcare. This makes Swedish real rates relatively attractive. We remain positive on the Swedish krona and believe that it will be one of the first to benefit, should global growth pick up.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com   Kelly Zhong, Research Analyst kellyz@bcaresearch.com Footnotes 1 We removed the shelter component in regression 1, since it was distorting results. 2 Please see Foreign Exchange Strategy Weekly Report, titled “Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much”, dated May 31, 2019, available at fes.bcaresearch.com 3 Please see “Survey of Household Spending, 2017,” Statistic Canada, December 12, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Today’s equity risk premium of 1.6 percent makes equities the preferred long-term asset-class versus bonds at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly. German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. We closed our tactical short in equities at its 4 percent profit-target, and are now tactically neutral. Fractal analysis suggests that bonds are now technically overbought… …but developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Feature Chart of the WeekStocks Set To Return 3 Percent, Bonds Set To Return 1.4 Percent Stocks Set To Return 3 Percent, Bonds Set To Return 1.4 Percent Stocks Set To Return 3 Percent, Bonds Set To Return 1.4 Percent Bonds Set To Return 1.4 Percent This year’s rally in bonds has dragged down bond yields to unprecedented lows. Indeed, in many markets, the term ‘bond return’ should more truthfully be called ‘bond penalty’. For example, with the German 10-year bund now yielding -0.7 percent, buying and holding it for its ten year life will lose you 7 percent of your money.1 Or will it? Unlike in most jurisdictions where the currency cannot disintegrate, euro area bond yields are complicated by ‘redenomination’ discounts and premiums. If you were certain that the euro was going to break up within the next ten years, and that the German bund would pay you back in new deutschmarks worth 7 percent more than euros, then the currency redenomination gain would more than cancel out the cumulative loss from the negative yield. For this reason a better measure of the euro area bond yield comes from the single currency bloc’s average yield – because in a break up, the expected currency gains and losses for the average euro area bond yield must sum to zero. To avoid the onerous calculation of this euro area average yield, a useful proxy turns out to be the French OAT yield. While not as depressed as the German bund yield, the 10-year OAT yield, at -0.35 percent, still constitutes a bond penalty (Chart I-2). The global bond yield has reached a new record low. Meanwhile, although the global 10-year bond yield is still positive, it recently fell to an all-time low of 1.40 percent – breaking the previous record low of 1.43 percent set in the aftermath of the 2016 shock vote for Brexit (Chart I-3). Chart I-2The French OAT Is A Good Proxy For The Average Euro Area Bond The French OAT Is A Good Proxy For The Average Euro Area Bond The French OAT Is A Good Proxy For The Average Euro Area Bond Chart I-3Bonds Set To Return##br## 1.4 Percent Bonds Set To Return 1.4 Percent Bonds Set To Return 1.4 Percent Stocks Set To Return 3 Percent    The long term prospective return from most asset-classes is well-defined: for the bond asset-class it is the yield to maturity, now at 1.4 percent;2 for the equity asset-class it comes from the starting valuation, which tends to be an excellent predictor of the long term prospective return. But which valuation metric? Equity valuations based on earnings are problematic – because valuations appear deceptively attractive when profit margins are structurally high, as they are now (Chart I-4). The problem is that earnings will face a structural headwind when margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this only corrects for the cycle and does not correct for any structural trend. Chart I-4Structurally High Profit Margins Flatter Equity Earnings Structurally High Profit Margins Flatter Equity Earnings Structurally High Profit Margins Flatter Equity Earnings Equity valuations based on assets are also problematic. Nowadays, such assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to quantify accurately. Hence, our preferred long-term valuation metric is price to sales – because sales are quantifiable, objective, and unambiguous. Indeed, the starting price to sales multiple of the global equity asset-class has been a near-perfect predictor of its prospective 10-year nominal return (Chart I-5). The method is to regress historic starting price to sales with (the known) prospective 10-year returns. Then apply the established relationship to the current price to sales to predict the (the unknown) prospective return. Chart I-5Stocks Set To Return 3 Percent Stocks Set To Return 3 Percent Stocks Set To Return 3 Percent On this basis, today’s prospective 10-year annualised return from global equities is 3 percent.  Is The 1.6 Percent Excess Return Enough? So the prospective 10-year return from equities, at an annualised 3 percent, is 1.6 percent more than that from bonds, at 1.4 percent.3 Is this excess return – the so-called ‘equity risk premium’ – enough (Chart of the Week)? Price to sales has been a near-perfect predictor of long term equity returns.   Yes, because at ultra-low bond yields, the risk of owning bonds converges with the risk of owning equities. The asymmetry in the future direction of bond yields makes bonds riskier investments. The short-term potential for capital appreciation – nominal or real – diminishes, while the potential for vicious losses increases dramatically. The technical term for this unattractive asymmetry is negative skew. Recent breakthroughs in risk theory and behavioural economics conclude that our perception of an investment’s risk does not come from its volatility or correlation characteristics. It comes from the investment’s negative skew. Chart I-6 The upshot is that today’s excess prospective return of 1.6 percent does make equities the preferred long-term asset-class at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly (Chart I-6). Interestingly, German equities are an excellent long-term proxy for global equities, producing near-identical returns (Chart I-7). This is not surprising given the very similar international and sector focusses. We can infer that the German stock market, just like the global equity asset-class, is set to deliver an annualised 10-year return of 3 percent. But in Germany, the 10-year bond yield is -0.7 percent, implying that German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. Chart I-7German Equities Are An Excellent Proxy For Global Equities German Equities Are An Excellent Proxy For Global Equities German Equities Are An Excellent Proxy For Global Equities Some Other Asset Allocation Thoughts The rally in bonds has hurt our cyclical overweight to the DAX versus long-dated German bunds. However, given the aforementioned long-term analysis, we are sticking with it, albeit switching it from a cyclical to a structural recommendation. Our other recent asset allocation recommendations have worked. In May, we pointed out that the simultaneous strong rallies in equities, bonds, and oil was extremely rare, and that at least one of the rallies would soon break down. This is precisely what happened. While bonds rallied a further 5 percent, equities corrected by 5 percent, and the crude oil price plunged 20 percent. However, our portfolio construction could have been better as our weightings in the three assets left the combined short position roughly flat. The position is now closed. Our tactical short in equities achieved its 4 percent profit-target. Likewise in June, fractal analysis suggested that the double-digit rally in stock markets was vulnerable to a countertrend reversal. This is precisely what happened. Our tactical short position in the MSCI AC World Index achieved its 4 percent profit-target and is now closed (Chart I-8). Stay tactically neutral to equities. Chart I-8Stocks Were Overbought, And Reversed Stocks Were Overbought, And Reversed Stocks Were Overbought, And Reversed Interestingly, the same fractal analysis is suggesting that it is the stellar rally in bonds that is now vulnerable to a countertrend reversal (Chart I-9), implying a tactical short position in bonds. Having said that, developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Chart I-9Bonds Are Overbought Bonds Are Overbought Bonds Are Overbought Fractal Trading System* This week we note that the sharp underperformance of Spain (IBEX 35) versus Belgium (BEL 20) is technically extended and susceptible to a liquidity-triggered reversal. Accordingly, the recommended trade is to go long Spain versus Belgium setting a profit-target of 3.5 percent with a symmetrical stop-loss. In the other trades, short MSCI All-Country World achieved its 4 percent profit-target and is now closed. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Spain VS. Belgium Spain VS. Belgium The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no default risk and no reinvestment risk. 2 Assuming no default risk and no reinvestment risk. 3 Nominal annualised total return, capital plus income. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal 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 Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion A Brief Inversion A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Low Yields Support Risk Assets I Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Low Yields Support Risk Assets II Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Global Growth Indicators Global Growth Indicators Chart 5Catalysts For Economic Recovery Catalysts For Economic Recovery Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta Global Yield Beta Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Negative Interest Rates: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields maintained outside of a growth slowdown to prove that thesis. USTs & Bunds: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.1 Feature Positive Headlines On Negative Yields? Investors should always be cautious of “new era” explanations to justify an elevated asset price after a massive rally. That is akin to internet stocks in the late 1990s that were valued on “clicks and eyeballs” in the absence of actual profits. Or the “peak oil” thesis, predicting an impending exhaustion of global petroleum supplies, that was trotted out during past periods when oil prices were already above $100/bbl. The latest such argument can be found in government bonds, where fundamental justifications for the growing inventory of negative yielding bonds being “the new normal” have started to proliferate. The arguments underlying the “Negative Normal Thesis” (which we will coin “NNT”, not to be confused with the MMT of Modern Monetary Theory!) are hardly new. Aging demographics, “savings gluts” and a dwindling supply of global safe assets have been widely cited as causes for low bond yields since early in the 21st century (remember former Fed Chair Alan Greenspan’s famous “bond conundrum”?). Proponents of NNT point to Japan as the textbook example of how rates can stay low forever when savings are high and demand for capital is low. They are now declaring the “Japanification” of Europe … with the U.S. next in line to eventually join the negative rate party. If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. Chart of the WeekIs This Really A “New Era” For Bond Yields? Is This Really A "New Era" For Bond Yields? Is This Really A "New Era" For Bond Yields? If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. For if negative yields are, in fact, structurally driven by excess savings and not just cyclically driven by weak nominal growth, then improving economic momentum should have little impact on the level of interest rates. That would be a true “Japanification” scenario. For now, as far as we can tell from the data, the big decline in bond yields over the past year can be fully explained by the classic drivers – slowing economic growth and soft inflation (Chart of the Week). Investors are keenly aware of the triggers for these moves by now: a) slowing global trade and capital spending, both victims of the ever-worsening U.S.-China trade dispute; b) the lagged impact of past monetary tightening (Fed rate hikes and, arguably, the end of ECB bond buying at the end of 2018); and c) the persistent strength of the U.S. dollar preventing global “reflation”. You do not have to be an aging saver to view those as good reasons to favor the near-term safety of government bonds. Right now, the steady drumbeat of weakening cyclical global growth indicators is fueling bullish bond sentiment, especially in the parts of the world most exposed to global trade like Europe. Looking ahead, however, we may get the first test of NNT much sooner than expected. The latest update of the OECD’s leading economic indicators (LEI) was released last week. The message is consistent with the modest improvement seen over the past several months (Chart 2), with meaningful gains seen in many economies sensitive to global growth like Mexico, Taiwan, Australia and, most importantly, China.   Our “leading leading” indicator – the diffusion index of the global LEI, which includes many of the individual country OECD LEIs – continues to show that the majority of countries are seeing a rise in their LEI. We have shown that the LEI diffusion index has, in the past, been a fairly reliable leading indicator of the direction of not only the global LEI itself but of global bond yields as well. At present, the relatively optimistic reading from the global LEI diffusion index is at odds with the sharp downward momentum in bond yields (see the middle panel of the Chart of the Week). NNT at work, or a sign of a bubble forming in government bond markets? Time will tell. To be sure, the shaken confidence of investors thanks to the intensifying U.S.-China trade dispute has likely weakened the link between growth and yields – at least temporarily. Investors need to see hard evidence that global growth is bottoming out before seriously reevaluating the current level of bond yields. Signs of improvement in Chinese growth momentum would go a long way to turning around depressed investor confidence. It is still a bit too soon, however, to expect a rebound in Chinese domestic demand given the long lags between leading indicators like the OECD measure (or the China credit impulse) and hard Chinese economic data (Chart 3). More likely, a change in trend for these series would not be visible until well into the 4th quarter of 2019, at the earliest. Chart 2A Ray Of Hope For Global Growth? A Ray Of Hope For Global Growth? A Ray Of Hope For Global Growth? Chart 3Still A Bit Too Soon To Expect A China Turnaround Still A Bit Too Soon To Expect A China Turnaround Still A Bit Too Soon To Expect A China Turnaround Signs of better growth in Europe – where negative bond yields are most prevalent, including in corporate bonds – would also help to reverse excessive investor pessimism. A turnaround there, however, also needs better growth in China, given the heavy exposure of European exporters to Chinese demand. So until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Bottom Line: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields sustained outside of a growth slowdown to prove that thesis. Have The Rallies In U.S. Treasuries & German Bunds Now Gone Too Far? Last week, we upgraded our overall global duration call to neutral on a tactical (0-3 month) basis.2 This was driven by the growing risk that the global central banks – most notably, the Federal Reserve – could be forced to become even more dovish because of the escalation in the U.S.-China trade war. Furthermore, our Global Duration Indicator has pulled back after the steady rise since late 2018, and is now in line with the aggregate level of 10-year bond yields in the major developed markets (Chart 4). This is consistent with a neutral tactical duration view. Chart 4The Signal From Our Duration Indicator Is Consistent With A Neutral Stance The Signal From Our Duration Indicator Is Consistent With A Neutral Stance The Signal From Our Duration Indicator Is Consistent With A Neutral Stance There are signs, however, that Treasuries are overbought: Even as Treasury yields are heading closer to the 2016 lows, U.S. inflation expectations derived from the TIPS market are closer to 2% than the lows below 1.5% seen in 2016 (Chart 5). That market pricing seems reasonable, with realized inflation higher, and the labor market tighter, than was the case three years ago. The price momentum for the 10-year Treasury yield is approaching the extremes seen in the “post Fed QE” era (Chart 6), with the 6-month rate of change of the Bloomberg Barclays U.S. Treasury index approaching 10%. The deviation of the 10-year Treasury yield from its 200-day moving average, which is also at the post-QE extreme of -75bps, tells a similar story. Chart 5A Different U.S. Inflation Backdrop Vs. 2016 A Different U.S. Inflation Backdrop Vs. 2016 A Different U.S. Inflation Backdrop Vs. 2016 Chart 6The Fall In UST Yields Looks Stretched The Fall In UST Yields Looks Stretched The Fall In UST Yields Looks Stretched Investor positioning has become VERY long, with the J.P. Morgan duration survey of Active Clients surging to the highest level in the two-decade history of the series (Chart 6, third panel). A similar story applies to the German bond market, where the entire yield curve out to 30-years is trading below 0% (raising a cheer from the NNTers): Market-based inflation expectations have collapsed, with the 5-year CPI swap, 5-years forward reaching a low of 1.2% – lower than 2016, despite a tighter overall euro area labor market, accelerating wage growth and core inflation remaining sticky around 1% (Chart 7). The 6-month total return of the German government bond index is reaching a post-European Debt Crisis extreme near 10%, while the 10-year Bund yield is trading around a similar extreme of 50bps below its 200-day moving average (Chart 8). Chart 7European Inflation: Expectations Worse Than Reality European Inflation: Expectations Worse Than Reality European Inflation: Expectations Worse Than Reality Chart 8The Fall in Bund Yields Is Looking Stretched The Fall in Bund Yields Is Looking Stretched The Fall in Bund Yields Is Looking Stretched While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. Bottom Line: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without durable signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A "New Negative" World For Bonds? Or Just The Latest Bubble? A "New Negative" World For Bonds? Or Just The Latest Bubble? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, In case you missed it in real time, please listen to a replay of this quarter’s webcast ‘The Investment World in 5 Charts and 18 Minutes’ available at eis.bcaresearch.com. Also please note that we will be taking a summer break, so our next report will come out on August 22. Dhaval Joshi Highlights The aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from a down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector and regional losers and winners. Economically-sensitive ‘value’ sectors will be the losers, specifically Industrials and Semiconductors. Defensive ‘growth’ sectors will be the relative winners, specifically Healthcare. Continue to overweight European equities versus Chinese equities. Feature Chart of the WeekThe Global Bond Yield Is Within A Whisker Of An All-Time Low The Global Bond Yield Is Within A Whisker Of An All-Time Low The Global Bond Yield Is Within A Whisker Of An All-Time Low This week the global long bond yield came within a whisker of the all-time low reached after the shock vote for Brexit in June 2016 (Chart of the Week). By definition, this means that the aggregate bond market has gone nowhere for several years. Since the autumn of 2017, the aggregate equity market has also gone nowhere, with no rally or sell-off lasting more than three months (Chart I-2).1 Chart I-2Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months The correct strategy then has been to sell the equity market’s three month rallies and buy the three month sell-offs. In June we predicted that equities would end the year at broadly the same level as then, but that they would experience a dip of at least 4-5 percent along the way. We are now experiencing the dip. The correct strategy has been to sell the three month rallies and buy the three month sell-offs. But isn’t the global bond yield approaching an all-time low a good thing for the economy and equity market? The answer is yes, and no. Yes, the ultra-low level of yields is a boon for the valuation of risk-assets. However, when it comes to credit-sourced economic growth, what matters is not the level of the bond yield, nor its direction, so much as its rate of change.      If Bond Yields Decline At A Reduced Pace, Growth Slows Many people struggle to understand this subtle and counterintuitive point. If the bond yield declines, but at a reduced pace, it can slow credit-sourced growth. To understand why, imagine that in a certain period, a -0.5 percent decline in the bond yield added €50 billion to credit creation. This would constitute additional economic demand. If, in the following period, a further -0.5 percent yield decline added another €50 billion of credit-sourced demand, it would constitute the same amount of additional demand – which is to say, the same growth – as in the first period. By comparison, a -0.25 percent yield decline which added €25 billion to demand would result in the growth rate halving. The subtle and counterintuitive point is that the bond yield has continued to decline, yet it has caused credit-sourced growth to slow! Chart I-3In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago This counterintuitive dynamic has unfolded in the global economy this year. Although bond yields have been heading lower, the peak rate of decline – notably in China – happened six months ago. Meaning that credit-sourced growth has almost certainly slowed (Chart I-3). Amplifying this down-oscillation in growth, geopolitical storm clouds are now regathering over the global economy. In the early part of this year, trade tensions and currency wars between the major economic blocs seemed to dissipate, the Middle East was quiet, and the Brexit deadline was postponed. But the lull was temporary. The geopolitical headwinds to growth are now strengthening with a vengeance. That’s the bad news.  Equity Valuations Are Hyper-Sensitive To Low Bond Yields Now the good news. While the level of bond yields does not drive economic growth, it does drive the valuations of equities and other risk-assets. Moreover, it does so in a powerful non-linear way. Below a threshold level, ultra-low bond yields can give the valuation of equities an exponential boost. Geopolitical storm clouds are now regathering over the global economy. We refer readers to our other reports for the details, but in a nutshell at ultra-low bond yields the risk of owning bonds converges to the risk of owning equities. The upshot of this risk convergence is that investors price equities to deliver the same feeble nominal return as bonds, meaning that the valuation of equities soars (Chart I-4).2 Chart I-4The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 Theoretically and empirically, this threshold level of the bond yield is in the region of 2 percent. And the bond yield that matters is the global long bond yield, defined as the simple average of the 10-year yields of the U.S., the euro area, and China. To simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China. A value rising towards 2.5 percent equates to danger for equity valuations. A value falling below 2.0 percent equates to an underpinning for equity valuations. Today, the value stands near 1.5 percent creating a good support for equity and risk-asset valuations. The upshot is that the aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from the down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector losers and winners. Essentially, economically-sensitive ‘value’ sectors will be the losers while defensive ‘growth’ sectors will be the relative winners. Put simply, the sector trends present during the last up-oscillation in global growth are likely to unwind if they have not already done so. In which case, the sectors most likely to suffer underperformance are:   Industrials and Semiconductors (Chart I-5). Chart I-5Industrials Outperformed Strongly... But Are Now Underperforming Industrials Outperformed Strongly... But Are Now Underperforming Industrials Outperformed Strongly... But Are Now Underperforming And the sector most likely to see (continued) outperformance is: Healthcare. There will also be regional losers and winners. This is because regional equity market relative performance just follows from sector relative performance combined with each region’s sector ‘fingerprint’. Bear in mind that a fingerprint can be defined not just by overweight sectors but also by underweight sectors, such as the Shanghai Composite’s negligible weighting in Healthcare, making the Chinese index ultra-cyclical. Continue to overweight European equities versus Chinese equities (Chart I-6).  Chart I-6Overweight Europe Versus China Overweight Europe Versus China Overweight Europe Versus China Market Dislocations And Recessions: Cause And Effect As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major dislocation in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months. There have been three such episodes in the twenty-first century.3 Yet our market based definition of a major dislocation also perfectly captures the three last times that the European economy went into recession or near-recession. Does this mean that the recessions caused the financial market dislocations? No. Quite the reverse. The twenty-first century’s recessions have all resulted from financial market dislocations. The twenty-first century’s recessions have all resulted from the financial market dislocations that followed market distortion or mispricing: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-7); the mispricing of U.S. mortgages and credit in 2007 (Chart I-8); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-9). Therefore, the major dislocations in the financial markets have always preceded the recessions and near-recessions, sometimes by several quarters, even when both are measured in real time. Chart I-7The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... Chart I-8...The Mispricing Of U.S.##br## Mortgages And Credit In##br## 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008...   Chart I-9...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 Today, the consensus overwhelmingly believes that a recession will cause the next major dislocation in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Hence, a major dislocation in the financial markets – should one occur – will cause the next recession. And not the other way round! Fractal Trading System* The nickel price has surged on continued fears over Indonesian exports bans. But from a technical perspective the recent surge is excessive and susceptible to a reversal on any easing of the fears. Accordingly, this week’s trade is short nickel versus copper, setting a profit target of 10 percent with a symmetrical stop-loss. In other trades, short ASX200 versus FTSE100 hit its 2 percent stop-loss, but short MSCI All-Country World has moved well into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10Short Nickel, Long Copper Short Nickel, Long Copper Short Nickel, Long Copper The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 We define the global long bond yield as the simple average of the 10-year yields in the U.S., euro area, and China. And to make things simple, France provides a good proxy for the euro area long bond yield. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com. 3 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 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