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Highlights We update our long-range forecasts of returns from a range of asset classes – equities, bonds, alternatives, and currencies – and make some refinements to the methodologies we used in our last report in November 2017. We add coverage of U.K., Australian, and Canadian assets, and include Emerging Markets debt, gold, and global Real Estate in our analysis for the first time. Generally, our forecasts are slightly higher than 18 months ago: we expect an annual return in nominal terms over the next 10-year years of 1.7% from global bonds, and 5.9% from global equities – up from 1.5% and 4.6% respectively in the last edition. Cheaper valuations in a number of equity markets, especially Japan, the euro zone, and Emerging Markets explain the higher return assumptions. Nonetheless, a balanced global portfolio is likely to return only 4.7% a year in the long run, compared to 6.3% over the past 20 years. That is lower than many investors are banking on. Feature Since we published our first attempt at projecting long-term returns for a range of asset classes in November 2017, clients have shown enormous interest in this work. They have also made numerous suggestions on how we could improve our methodologies and asked us to include additional asset classes. This Special Report updates the data, refines some of our assumptions, and adds coverage of U.K., Australian, and Canadian assets, as well as gold, global Real Estate, and global REITs. Our basic philosophy has not changed. Many of the methodologies are carried over from the November 2017 edition, and clients interested in more detailed explanations should also refer to that report.1 Our forecast time horizon is 10-15 years. We deliberately keep this vague, and avoid trying to forecast over a 3-7 year time horizon, as is common in many capital market assumptions reports. The reason is that we want to avoid predicting the timing and gravity of the next recession, but rather aim to forecast long-term trend growth irrespective of cycles. This type of analysis is, by nature, as much art as science. We start from the basis that historical returns, at least those from the past 10 or 20 years, are not very useful. Asset allocators should not use historical returns data in mean variance optimizers and other portfolio-construction models. For example, over the past 20 years global bonds have returned 5.3% a year. With many long-term government bonds currently yielding zero or less, it is mathematically almost impossible that returns will be this high over the coming decade or so. Our analysis points to a likely annual return from global bonds of only 1.7%. Our approach is based on building-blocks. There are some factors we know with a high degree of certainly: such as the return on U.S. 10-year Treasury yields over the next 10 years (to all intents and purposes, it is the current yield). Many fundamental drivers of return (credit spreads, the small-cap premium, the shape of the yield curve, profit margins, stock price multiples etc.) are either steady on average over the cycle, or mean revert. For less certain factors, such as economic growth, inflation, or equilibrium short-term interest rates, we can make sensible assumptions. Most of the analysis in this report is based on the 20-year history of these factors. We used 20 years because data is available for almost all the asset classes we cover for this length of time (there are some exceptions, for example corporate bond data for Australia and Emerging Markets go back only to 2004-5, and global REITs start only in 2008). The period from May 1999 to April 2019 is also reasonable since it covers two recessions and two expansions, and started at a point in the cycle that is arguably similar to where we are today. Some will argue that it includes the Technology bubble of 1999-2000, when stock valuations were high, and that we should use a longer period. But the lack of data for many assets classes before the 1990s (though admittedly not for equities) makes this problematic. Also, note that the historical returns data for the 20 years starting in May 1999 are quite low – 5.8% for U.S. equities, for example. This is because the starting-point was quite late in the cycle, as we probably also are now.   We make the following additions and refinements to our analysis: Add coverage of the U.K., Australia, and Canada for both fixed income and equities. Add coverage of Emerging Markets debt: U.S. dollar and local-currency sovereign bonds, and dollar-denominated corporate credit. Among alternative assets, add coverage of gold, global Direct Real Estate, and global REITs. Improve the methodology for many alt asset classes, shifting from reliance on historical returns to an approach based on building blocks – for example, current yield plus an estimation of future capital appreciation – similar to our analysis of other asset classes. In our discussion of currencies, add for easy reference of readers a table of assumed returns for all the main asset classes expressed in USD, EUR, JPY, GBP, AUD, and CAD (using our forecasts of long-run movements in these currencies). Added Sharpe ratios to our main table of assumptions. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in U.S. dollars). Table 1BCA Assumed Returns Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Unsurprisingly, given the long-term nature of this exercise, our return projections have in general not moved much compared to those in November 2017. Indeed, markets look rather similar today to 18 months ago: the U.S. 10-year Treasury yield was 2.4% at end-April (our data cut-off point), compared to 2.3%, and the trailing PE for U.S. stocks 21.0, compared to 21.6. If anything, the overall assumption for a balanced portfolio (of 50% equities, 30% bonds, and 20% equal-weighted alts) has risen slightly compared to the 2017 edition: to 4.7% from 4.1% for a global portfolio, and to 4.9% from 4.6% for a purely U.S. one. That is partly because we include specific forecasts for the U.K., Australia, and Canada, where returns are expected to be slightly higher than for the markets we limited our forecasts to previously, the U.S, euro zone, Japan, and Emerging Markets (EM). Equity returns are also forecast to be higher than 18 months ago, mainly because several markets now are cheaper: trailing PE for Japan has fallen to 13.1x from 17.6x, for the euro zone to 15.5x from 18.0x, and for Emerging Markets to 13.6x from 15.4x (and more sophisticated valuation measures show the same trend). The long-term picture for global growth remains poor, based on our analysis, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. We include Sharpe ratios in Table 1 for the first time. We calculate them as expected return/expected volatility to allow for comparison between different asset classes, rather than as excess return over cash/volatility as is strictly correct, and as should be used in mean variance optimizers. Chart 1Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns For volatility assumptions, we mostly use the 20-year average volatility of each asset class. As discussed above, historical returns should not be used to forecast future returns. But volatility does not trend much over the long-term (Chart 1). We looked carefully at volatility trends for all the asset classes we cover, but did not find a strong example of a trend decline or rise in any. We do, however, adjust the historic volatility of the illiquid, appraisal-based alternative assets, such as Private Equity, Real Estate, and Farmland. The reported volatility is too low, for example 2.6% in the case of U.S. Direct Real Estate. Even using statistical techniques to desmooth the return produces a volatility of only around 7%. We choose, therefore, to be conservative, and use the historic volatility on REITs (21%) and apply this to Direct Real Estate too. For Private Equity (historic volatility 5.9%), we use the volatility on U.S. listed small-cap stocks (18.6%). Looking at the forecast Sharpe ratios, the risk-adjusted return on global bonds (0.55) is somewhat higher than that of global equities (0.33). Credit continues to look better than equities: Sharpe ratio of 0.70 for U.S. investment grade debt and 0.62 for high-yield bonds. Nonetheless, our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. Over the past 20 years a global balanced portfolio (defined as above) returned 6.3% and a similar U.S. portfolio 7.0%. We expect 4.7% and 4.9% respectively in future. Investors working on the assumption of a 7-8% nominal return – as is typical among U.S. pension funds, for example – need to become realistic. Below follow detailed descriptions of how we came up with our assumptions for each asset class (fixed income, equities, and alternatives), followed by our forecasts of long-term currency movements, and a brief discussion of correlations. 1. Fixed Income We carry over from the previous edition our building-block approach to estimating returns from fixed income. One element we know with a relatively high degree of certainty is the return over the next 10 years from 10-year government bonds in developed economies: one can safely assume that it will be the same as the current 10-year yield. It is not mathematical identical, of course, since this calculation does not take into account reinvestment of coupons, or default risk, but it is a fair assumption. We can make some reasonable assumptions for returns from cash, based on likely inflation and the real equilibrium cash rate in different countries. After this, our methodology is to assume that other historic relationships (corporate bond spreads, default and recovery rates, the shape of the yield curve etc.) hold over the long run and that, therefore, the current level reverts to its historic mean. The results of our analysis, and the assumptions we use, are shown in Table 2. Full details of the methodology follow below. Table 2Fixed Income Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Projected returns have not changed significantly from the 2017 edition of this report. In the U.S., for the current 10-year Treasury bond yield we used 2.4% (the three-month average to end-April), very similar to the 2.3% on which we based our analysis in 2017. In the euro zone and Japan, yields have fallen a little since then, with the 10-year German Bund now yielding roughly 0%, compared to 0.5% in 2017, and the Japanese Government Bond -0.1% compared to zero. Overall, we expect the Bloomberg Barclays Global Index to give an annual nominal return of 1.7% over the coming 10-15 years, slightly up from the assumption of 1.5% in the previous edition. This small rise is due to the slight increase in the U.S. long-term risk-free rate, and to the inclusion for the first time of specific estimates for returns in the U.K., Australia, and Canada. Fixed Income Methodologies Cash. We forecast the long-run rate on 3-month government bills by generating assumptions for inflation and the real equilibrium cash rate. For inflation, in most countries we use the 20-year average of CPI inflation, for example 2.2% in the U.S. and 1.7% in the euro zone. This suggests that both the Fed and the ECB will slightly miss their inflation targets on the downside over the coming decade (the Fed targets 2% PCE inflation, but the PCE measure is on average about 0.5% below CPI inflation). Of course, this assumes that the current inflation environment will continue. BCA’s view is that inflation risks are significantly higher than this, driven by structural factors such as demographics, populism, and the advent of ultra-unorthodox monetary policy.2 But we see this as an alternative scenario rather than one that we should use in our return assumptions for now. Japan’s inflation has averaged 0.1% over the past 20 years, but we used 1% on the grounds that the Bank of Japan (BoJ) should eventually see some success from its quantitative easing. For the equilibrium real rate we use the New York Fed’s calculation based on the Laubach-Williams model for the U.S., euro zone, U.K., and Canada. For Japan, we use the BoJ’s estimate, and for Australia (in the absence of an official forecast of the equilibrium rate) we take the average real cash rate over the past 20 years. Finally, we assume that the cash yield will move from its current level to the equilibrium over 10 years. Government Bonds. Using the 10-year bond yield as an anchor, we calculate the return for the government bond index by assuming that the spread between 7- and 10-year bonds, and between 3-month bills and 10-year bonds will average the same over the next 10 years as over the past 20. While the shape of the yield curve swings around significantly over the cycle, there is no sign that is has trended in either direction (Chart 2). The average maturity of government bonds included in the index varies between countries: we use the five-year historic average for each, for example, 5.8 years for the U.S., and 10.2 years for Japan. Spread Product. Like government bonds, spreads and default rates are highly cyclical, but fairly stable in the long run (Chart 3). We use the 20-year average of these to derive the returns for investment-grade bonds, high-yield (HY) bonds, government-related securities (e.g. bonds issued by state-owned entities, or provincial governments), and securitized bonds (e.g. asset-backed or mortgage-backed securities). For example, for U.S. high-yield we use the average spread of 550 basis points over Treasuries, default rate of 3.8%, and recovery rate of 45%. For many countries, default and recovery rates are not available and so we, for example, use the data from the U.S. (but local spreads) to calculate the return for high-yield bonds in the euro zone and the U.K. Inflation-Linked Bonds. We use the average yield over the past 10 years (not 20, since for many countries data does not go back that far and, moreover, TIPs and their equivalents have been widely used for only a relatively short period.) We calculate the return as the average real yield plus forecast inflation. Chart 2Yield Curves Yield Curves Yield Curves Chart 3Credit Spreads & Default Rates Credit Spreads & Defaykt Rates Credit Spreads & Defaykt Rates     Bloomberg Barclays Aggregate Bond Indexes. We use the weights of each category and country (from among those we forecast) to derive the likely return from the index. The composition of each country’s index varies widely: for example, in the euro zone (27% of the global bond index), government bonds comprise 66% of the index, but in the U.S. only 37%. Only the U.S. and Canada have significant weightings in corporate bonds: 29% and 50% respectively. This can influence the overall return for each country’s index. Table 3Emerging Market Debt Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Emerging Market Debt. We add coverage of EMD: sovereign bonds in both local currency and U.S. dollars, and USD-denominated EM corporate debt. Again, we take the 20-year average spread over 10-year U.S. Treasuries for each category. A detailed history of default and recovery is not available, so for EM corporate debt we assume similar rates to those for U.S. HY bonds. For sovereign bonds, we make a simple assumption of 0.5% of losses per year – although in practice this is likely to be very lumpy, with few defaults for years, followed by a rush during an EM crisis. For EM local currency debt, we assume that EM currencies will depreciate on average each year in line with the difference between U.S. inflation and EM inflation (using the IMF forecast for both – please see the Currency section below for further discussion on this). After these calculations, we conclude that EM USD sovereign bonds will produce an annual return of 4.7%, and EM USD corporate bonds 4.5% – in both cases a little below the 5.6% return assumption we have for U.S. high-yield debt (Table 3).   2. Equities Our equity methodologies are largely unchanged from the previous edition. We continue to use the return forecast from six different methodologies to produce an average assumed return. Table 4 shows the results and a summary of the calculation for each methodology. The explanation for the six methodologies follows below. Table 4Equity Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined The results suggest slightly higher returns than our projections in 2017. We forecast global equities to produce a nominal annual total return in USD of 5.9%, compared to 4.6% previously. The difference is partly due to the inclusion for the first time of specific forecasts for the U.K., Australia and Canada, which are projected to see 8.0%, 7.4% and 6.0% returns respectively. The projection for the U.S. is fairly similar to 2017, rising slightly to 5.6% from 5.0% (mainly due to a slightly higher assumption for productivity growth in future, which boosts the nominal GDP growth assumption). Japan, however, does come out looking significantly more attractive than previously, with an assumed return of 6.2%, compared to 3.5% previously. This is mostly due to cheaper valuations, since the growth outlook has not improved meaningfully. Japan now trades on a trailing PE of 13.1x, compared to 17.6x in 2017. This helps improve the return indicated by a number of the methodologies, including earnings yield and Shiller PE. The forecast for euro zone equities remains stable at 4.7%. EM assumptions range more widely, depending on the methodology used, than do those for DM. On valuation-based measures (Shiller PE, earnings yield etc.), EM generally shows strong return assumptions. However, on a growth-based model it looks less attractive. We continue to use two different assumptions for GDP growth in EM. Growth Model (1) is based on structural reform taking place in Emerging Markets, which would allow productivity growth to rebound from its current level of 3.2% to the 20-year average of 4.1%; Growth Model (2) assumes no reform and that productivity growth will continue to decline, converging with the DM average, 1.1%, over the next 10 years. In both cases, the return assumption is dragged down by net issuance, which we assume will continue at the 10-year average of 4.9% a year. Our composite projection for EM equity returns (in local currencies) comes out at 6.6%, a touch higher than 6.0% in 2017. Equity Methodologies Equity Risk Premium (ERP). This is the simplest methodology, based on the concept that equities in the long run outperform the long-term risk-free rate (we use the 10-year U.S. Treasury yield) by a margin that is fairly stable over time. We continue to use 3.5% as the ERP for the U.S., based on analysis by Dimson, Marsh and Staunton of the average ERP for developed markets since 1900. We have, however, tweaked the methodology this time to take into account the differing volatility of equity markets, which should translate into higher returns over time. Thus we use a beta of 1.2 for the euro zone, 0.8 for Japan, 0.9 for the U.K., 1.1 for both Australia and Canada, and 1.3 for Emerging Markets. The long-term picture for global growth remains poor, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. Growth Model. This is based on a Gordon growth model framework that postulates that equity returns are a function of dividend yield at the starting point, plus the growth of earnings in future (we assume that the dividend payout ratio stays constant). We base earnings growth off assumptions of nominal GDP growth (see Box 1 for how we calculate these). But historically there is strong evidence that large listed company earnings underperform nominal GDP growth by around 1 percentage point a year (largely because small, unlisted companies tend to show stronger growth than the mature companies that dominate the index) and so we deduct this 1% to reach the earnings growth forecast. We also need to adjust dividend yield for share buybacks which in the U.S., for tax reasons, have added 0.5% to shareholder returns over the past 10 years (net of new share issuance). In other countries, however, equity issuance is significantly larger than buybacks; this directly impacts shareholders’ returns via dilution. For developed markets, the impact of net equity issuance deducts 0.7%-2.7% from shareholder returns annually. But the impact is much bigger in Emerging Markets, where dilution has reduced returns by an average of 4.9% over the past 10 years. Table 5 shows that China is by far the biggest culprit, especially Chinese banks. Table 5Dilution In Emerging Markets Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined BOX 1 Estimating GDP Growth We estimate nominal GDP growth for the countries and regions in our analysis as the sum of: annual growth in the working-age population, productivity growth, and inflation (we assume that capital deepening remains stable over the period). Results are shown in Table 6. Table 6Calculations Of Trend GDP Growth Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined For population growth, we use the United Nations’ median scenario for annual growth in the population aged 25-64 between 2015 and 2030. This shows that the euro zone and Japan will see significant declines in the working population. The U.S. and U.K. look slightly better, with the working population projected to grow by 0.3% and 0.1% respectively. There are some uncertainties in these estimates. Stricter immigration policies would reduce the growth. Conversely, greater female participation, a later retirement age, longer working hours, or a rise in the participation rate would increase it. For emerging markets we used the UN estimate for “less developed regions, excluding least developed countries”. These countries have, on average, better demographics. However, the average number hides the decline in the working-age population in a number of important EM countries, for example China (where the working-age population is set to shrink by 0.2% a year), Korea (-0.4%), and Russia (-1.1%). By contrast, working population will grow by 1.7% a year in Mexico and 1.6% in India. For productivity growth, we assume – perhaps somewhat optimistically – that the decline in productivity since the Global Financial Crisis will reverse and that each country will return to the average annual productivity growth of the past 20 years (Chart 4). Our argument is that the cyclical factors that depressed productivity since the GFC (for example, companies’ reluctance to spend on capex, and shareholders’ preference for companies to pay out profits rather than to invest) should eventually fade, and that structural and technical factors (tight labor markets, increasing automation, technological breakthroughs in fields such as artificial intelligence, big data, and robotics) should boost productivity. Based on this assumption, U.S. productivity growth would average 2.0% over the next 10-15 years, compared to 0.5% since 1999. Note that this is a little higher than the Congressional Budgetary Office’s assumption for labor productivity growth of 1.8% a year. Chart 4AProductivity Growth (I) Productivity Growth (I) Productivity Growth (I) Chart 4BProductivity Growth (II) Productivity Growth (II) Productivity Growth (II) Our assumptions for inflation are as described above in the section on Fixed Income. The overall results suggest that Japan will see the lowest nominal GDP growth, at 0.9% a year, with the U.S. growing at 4.4%. The U.K. and Australia come out only a little lower than the U.S. For emerging markets, as described in the main text, we use two scenarios: one where productivity grow continues to slow in the absence of reforms, especially in China, from the current 3.2% to converge with the average in DM (1.1%) over the next 10-15 years; and an alternative scenario where reforms boost productivity back to the 20-year average of 4.1%.   Growth Plus Reversion To Mean For Margins And Profits. There is logic in arguing that profit margins and multiples tend to revert to the mean over the long term. If margins are particularly high currently, profit growth will be significantly lower than the above methodology would suggest; multiple contraction would also lower returns. Here we add to the Growth Model above an assumption that net profit margin and trailing PE will steadily revert to the 20-year average for each country over the 10-15 years. For most countries, margins are quite high currently compared to history: 9.2% in the U.S., for example, compared to a 20-year average of 7.7%. Multiples, however, are not especially high. Even in the U.S. the trailing PE of 21.0x, compares to a 20-year average of 20.8x (although that admittedly is skewed by the ultra-high valuations in 1999-2000, and coming out of the 2007-9 recession – we would get a rather lower number if we used the 40-year average). Indeed, in all the other countries and regions, the PE is currently lower than the 20-year average. Note that for Japan, we assumed that the PE would revert to the 20-year average of the U.S. and the euro zone (19.2), rather than that of Japan itself (distorted by long periods of negative earnings, and periods of PE above 50x in the 1990s and 2000s).  Earnings Yield. This is intuitively a neat way of thinking about future returns. Investors are rewarded for owning equity, either by the company paying a dividend, or by reinvesting its earnings and paying a dividend in future. If one assumes that future return on capital will be similar to ROC today (admittedly a rash assumption in the case of fast-growing companies which might be tempted to invest too aggressively in the belief that they can continue to generate rapid growth) it should be immaterial to the investor which the company chooses. Historically, there has been a strong correlation between the earnings yield (the inverse of the trailing PE) and subsequent equity returns, although in the past two decades the return has been somewhat higher that the EY suggested, and so in future might be somewhat lower. This methodology produces an assumed return for U.S. equities of 4.8% a year. Shiller PE. BCA’s longstanding view is that valuation is not a good timing tool for equity investment, but that it is crucial to forecasting long-term returns. Chart 5 shows that there is a good correlation in most markets between the Shiller PE (current share price divided by 10-year average inflation-adjusted earnings) and subsequent 10-year equity returns. We use a regression of these two series to derive the assumptions. This points to returns ranging from 5.4% in the case of the U.S. to 12.5% for the U.K. Composite Valuation Indicator. There are some issues that make the Shiller PE problematical. It uses a fixed 10-year period, whereas cycles vary in length. It tends to make countries look cheap when they have experienced a trend decline in earnings (which may continue, and not mean revert) and vice versa. So we also use a proprietary valuation indicator comprising a range of standard parameters (including price/book, price/cash, market cap/GDP, Tobin’s Q etc.), and regress this against 10-year returns. The results are generally similar to those using the Shiller PE, except that Japan shows significantly higher assumed returns, and the U.K. and EM significantly lower ones (Chart 6). Chart 5Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Chart 6Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return     3. Alternative Investments We continue to forecast each illiquid alternative investment separately, but we have made a number of changes to our methodologies. Mostly these involve moving away from using historical returns as a basis for our forecasts, and shifting to an approach based on current yield plus projected future capital appreciation. In direct real estate, for example, in 2017 we relied on a regression of historical returns against U.S. nominal GDP growth. We move in this edition to an approach based on the current cap rate, plus capital appreciation (based on forecasts of nominal GDP growth), and taking into account maintenance costs (details below). We also add coverage of some additional asset classes: global ex-U.S. direct real estate, global ex-U.S. REITs, and gold. Table 7 summarizes our assumptions, and provides details of historic returns and volatility. Table 7Alternatives Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined It is worth emphasizing here that manager selection is far more important for many alternative investment classes than it is for public securities (Chart 7). There is likely to be, therefore, much greater dispersion of returns around our assumptions than would be the case for, say, large-cap U.S. equities. Chart 7For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key Hedge Funds Chart 8Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge fund returns have trended down over time (Chart 8). Long gone is the period when hedge funds returned over 20% per year (as they did in the early 1990s). Over the past 10 years, the Composite Hedge Fund Index has returned annually 3.3% more than 3-month U.S. Treasury bills. But that was entirely during an economic expansion and so we think it is prudent to cut last edition’s assumption of future returns of cash-plus-3.5%, to cash-plus-3% going forward. Direct Real Estate Our new methodology for real estate breaks down the return, in a similar way to equities, into the current cash yield (cap rate) plus an assumption of future capital growth. For the cap rate, we use the average, weighted by transaction volumes, of the cap rates for apartments, office buildings, retail, industrial real estate, and hotels in major cities (for example, Chicago, Los Angeles, Manhattan, and San Francisco for the U.S., or Osaka and Tokyo for Japan). We assume that capital values grow in line with each’s country’s nominal GDP growth (using the IMF’s five-year forecasts for this). We deduct a 0.5% annual charge for maintenance, in line with industry practice. Results are shown in Table 8. Our assumptions point to better returns from real estate in the U.S. than in the rest of the world. Not only is the cap rate in the U.S. higher, but nominal GDP growth is projected to be higher too. Table 8Direct Real Estate Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined REITs We switch to a similar approach for REITs. Previously we used a regression of REITs against U.S. equity returns (since REITs tend to be more closely correlated with equities than with direct real estate). This produced a rather high assumption for U.S. REITs of 10.1%. We now use the current dividend yield on REITs plus an assumption that capital values will grow in line with nominal GDP growth forecasts. REITs’ dividend yields range fairly narrowly from 2.9% in Japan to 4.7% in Canada. We do not exclude maintenance costs since these should already be subtracted from dividends. The result of using this methodology is that the assumed return for U.S. REITs falls to a more plausible 8.5%, and for global REITs is 6.2%. Private Equity & Venture Capital Chart 9Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around It makes sense that Private Equity returns are correlated with returns from listed equities. Most academic studies have shown a premium over time for PE of 5-6 percentage points (due to leverage, a tilt towards small-cap stocks, management intervention, and other factors). However, this premium has swung around dramatically over time (Chart 9). Over the past 10 years, for example, annual returns from Private Equity and listed U.S. equities have been identical: 12%. However, there appears to be no constant downtrend and so we think it advisable to use the 30-year average premium: 3.4%. This produces a return assumption for U.S. Private Equity of 8.9% per year. Over the same period, Venture Capital has returned around 0.5% more than PE (albeit with much higher volatility) and we assume the same will happen going forward.   Structured Products In the context of alternative asset classes, Structured Products refers to mortgage-backed and other asset-backed securities. We use the projected return on U.S. Treasuries plus the average 20-year spread of 60 basis points. Assumed return is 2.7%. Farmland & Timberland Chart 10Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP As with Real Estate and REITs, we move to a methodology using current cash yield (after costs) plus an assumption for capital appreciation linked to nominal GDP forecasts. The yield on U.S. Farmland is currently 4.4% and on Timberland 3.2%. Both have seen long-run prices grow significantly more slowly than nominal GDP growth. Since 1980, for example, farm prices have risen at a compound rate of 3.9% per acre, compared to U.S. nominal GDP growth of 5.2% and global GDP growth of 5.5% (Chart 10). We assume that this trend will continue, and so project farm prices to grow 1.5 percentage points a year more slowly than global GDP (using global, not U.S., economic growth makes sense since demand for food is driven by global factors). This produces a total return assumption of 6%. For timberland, we did not find a consistent relationship with nominal GDP growth and so assumed that prices would continue to grow at their historic rate over the past 20 years (the longest period for which data is available). We project timberland to produce an annual return of 4.8%. Commodities & Gold For commodities we use a very different methodology (which we also used in the previous edition): the concept that commodities prices consistently over time have gone through supercycles, lasting around 10 years, followed by bear markets that have lasted an average of 17 years (Chart 11). The most recent super-cycle was 2002-2012. In the period since the supercycle ended, the CRB Index has fallen by 42%. Comparing that to the average drop in the past three bear markets, we conclude that there is about 8% left to fall over the next nine years, implying an annual decline of about 1%. Our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. We add gold to our assumptions, since it is an asset often held by investors. However, it is not easy to project long-term returns for the metal. Since the U.S. dollar was depegged from gold in 1968, gold too has gone through supercycles, in the 1970s and 2002-11 (Chart 12). We find that change in real long-term interest rates negatively affects gold (logically since higher rates increase the opportunity cost of owning a non-income-generating asset). We use, therefore, a regression incorporating global nominal GDP growth and a projection of the annual change in real 10-year U.S. Treasury yields (based on the equilibrium cash rate plus the average spread between 10-year yields and cash). This produces an assumption of an annual return from gold of 4.7% a year. We continue to see this asset class more as a hedge in a portfolio (it has historically had a correlation of only 0.1 with global equities and 0.24 with global bonds) rather than a source of return per se.  Chart 11Commodities Still In A Bear Market Commodities Still In A Bear Market Commodities Still In A Bear Market Chart 12Gold Also Has Supercycles Gold Also Has Supercycles Gold Also Has Supercycles   4. Currencies Chart 13Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP All the return projections in this report are in local currency terms. That is a problem for investors who need an assumption for returns in their home currency. It is also close to impossible to hedge FX exposure over as long a period as 10-15 years. Even for investors capable of putting in place rolling currency hedges, GAA has shown previously that the optimal hedge ratio varies enormously depending on the home currency, and that dynamic hedges (i.e. using a simple currency forecasting model) produce better risk-adjust returns than a static hedge.3  Fortunately, there is an answer: it turns out that long-term currency forecasting is relatively easy due to the consistent tendency of currencies, in developed economies at least, to revert to Purchasing Power Parity (PPP) over the long-run, even though they can diverge from it for periods as long as five years or more (Chart 13). We calculate likely currency movements relative to the U.S. dollar based on: 1) the current divergence of the currency from PPP, using IMF estimates of the latter; 2) the likely change in PPP over the next 10 years, based on inflation differentials between the country and the U.S. going forward (using IMF estimates of average CPI inflation for 2019-2024 and assuming the same for the rest of the period). The results are shown in Table 9. All DM currencies, except the Australian dollar, look cheap relative to the U.S. dollar, and all of them, again excluding Australia, are forecast to run lower inflation that the U.S. implying that their PPPs will rise further. This means that both the euro and Japanese yen would be expected to appreciate by a little more than 1% a year against the U.S. dollar over the next 10 years or so. Table 9Currency Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined PPP does not work, however, for EM currencies. They are all very cheap relative to PPP, but show no clear trend of moving towards it. The example of Japan in the 1970s and 1980s suggests that reversion to PPP happens only when an economy becomes fully developed (and is pressured by trading partners to allow its currency to appreciate). One could imagine that happening to China over the next 10-20 years, but the RMB is currently 48% undervalued relative to PPP, not so different from its undervaluation 15 years ago. For EM currencies, therefore, we use a different methodology: a regression of inflation relative to the U.S. against historic currency movements. This implies that EM currencies are driven by the relative inflation, but that they do not trend towards PPP. Based on IMF inflation forecasts, many Emerging Markets are expected to experience higher inflation than the U.S. (Table 10). On this basis, the Turkish lira would be expected to decline by 7% a year against the U.S. dollar and the Brazilian real by 2% a year. However, the average for EM, which we calculated based on weights in the MSCI EM equity index, is pulled down by China (29% of that index), Korea (15%) and Taiwan (12%). China’s inflation is forecast to be barely above that in the U.S, and Korean and Taiwanese inflation significantly below it. MSCI-weighted EM currencies, consequently, are forecast to move roughly in line with the USD over the forecast horizon. One warning, though: the IMF’s inflation forecasts in some Emerging Markets look rather optimistic compared to history: will Mexico, for example, see only 3.2% inflation in future, compared to an average of 5.7% over the past 20 years? Higher inflation than the IMF forecasts would translate into weaker currency performance. Table 10EM Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined In Table 11, we have restated the main return assumptions from this report in USD, EUR, JPY, GBP, AUD, and CAD terms for the convenience of clients with different home currencies. As one would expect from covered interest-rate parity theory, the returns cluster more closely together when expressed in the individual currencies. For example, U.S. government bonds are expected to return only 0.8% a year in EUR terms (versus 2.1% in USD terms) bringing their return closer to that expected from euro zone government bonds, -0.4%. Convergence to PPP does not, however, explain all the difference between the yields in different countries. Table 11Returns In Different Base Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined 5. Correlations Chart 14Correlations Are Hard To Forecast Correlations Are Hard To Forecast Correlations Are Hard To Forecast We have not tried to forecast correlations in this Special Report. As discussed, historical returns from different asset classes are not a reliable guide to future returns, but it is possible to come up with sensible assumptions about the likely long-run returns going forward. Volatility does not trend much over the long term, so we think it is not unreasonable to use historic volatility data in an optimizer. But correlation is a different matter. As is well known, the correlation of equities and bonds has moved from positive to negative over the past 40 years (mainly driven by a shift in the inflation environment). But the correlation between major equity markets has also swung around (Chart 14). Asset allocators should preferably use rough, conservative assumptions for correlations – for example, 0.1 or 0.2 for the equity/bond correlation, rather than the average -0.1 of the past 20 years. We plan to do further work to forecast correlations in a future edition of this report.  But for readers who would like to see – and perhaps use – historic correlation data, we publish below a simplified correlation matrix of the main asset classes that we cover in this report (Table 12). We would be happy to provide any client with the full spreadsheet of all asset classes . Table 12Correlation Matrix Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Special Report, “What Returns Can You Expect?”, dated 15 November 2017, available at gaa.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated 22 May 2019, available at gaa.bcaresearch.com 3      Please see GAA Special Report, “Currency Hedging: Dynamic Or Static? A Practical Guide For Global Equity Investors,” dated 29 September 2017, available at gaa.bcaresearch.com  

Highlights The unifying chorus among global central banks is currently for more monetary stimulus. In the race towards lower interest rates, the ultimate winners will be pro-cyclical currencies. Italian 10-year real government bond yields are rapidly joining those in Spain and Portugal in being below the neutral rate of interest for the entire euro zone. This is hugely reflationary. That said, growth barometers remain in freefall, suggesting some patience is still warranted.  We are watching like hawks a few key crosses that are sitting at critical technical levels. A break below will signal we are entering a deflationary bust. A bounce could be a prologue to a reflationary rally. Watch the bond-to-gold ratio to gauge where the balance of forces are shifting for the U.S. dollar. Tepid action by the BoJ this week reinforces our view that the path towards additional stimulus will be lined by a stronger yen. Stay short USD/JPY. We were a few pips away from our stop loss on long GBP/USD this week. Stand aside if triggered. The Norges Bank has emerged as the most hawkish G10 central bank. Hold long NOK/SEK and short CAD/NOK positions. Feature As early as 1625, Hugo De Groot, then a Dutch philosopher, saw the act of pre-emptively striking an enemy as a move of self-defense. With a mandate of self-preservation, it made sense for a country to wage war for injury not yet done, if sufficient evidence pointed to colossal damage from no action. So faced with some important central bank meetings this week, and European manufacturing data well into freefall, the European Central Bank pulled a trick out of an old playbook. At an ECB forum in Sintra, Portugal, President Mario Draghi highlighted that if the inflation outlook failed to improve, the central bank had considerable headroom to launch a fresh expansion of its balance sheet. With its next policy meeting not until July 25th, it sure did feel like the ECB was cornered. What followed was as expected, a more dovish Federal Reserve, Bank Of Japan and Bank of England. Paradoxically, those two words might have opened a reflationary window and triggered one of the necessary catalysts for a sharp selloff in the U.S. dollar (Chart I-1). Time Lags The key question today is whether central banks have sufficiently eased policy to stem the decline in manufacturing data. Obviously, the trade war remains a key risk to whatever direction indicators might be pointing to today, but a few key observations are in order. Chart I-1A Countertrend Rally Underway A Countertrend Rally Underway A Countertrend Rally Underway Chart I-2Dovish Central Banks Should Help Growth Dovish Central Banks Should Help Growth Dovish Central Banks Should Help Growth Our global monetary policy barometer tends to lead the PMI by about six months. It tracks 29 central banks, gauging which have tightened policy over the last three months and which have not. Since the global financial crisis, whenever the measure has hit the critical threshold of 15-20%, it has correctly signaled that the pace of manufacturing activity is likely to slow. It is entirely another debate whether or not the world we live in today can tolerate higher interest rates, but our barometer has clearly plunged into reflationary territory – below the 20% threshold. This has usually been followed by a pick-up in manufacturing activity (Chart I-2). Data out of Singapore has been a timely tracker of global trade and warrants monitoring. Most real-time measures of economic activity remain weak, especially in the export sector, but it appears shipping activity may have been picking up pace over the past few months. Both the Harpex Shipping Index and the Baltic Dry Index have been perking up. Similarly, vessel arrivals into Singapore that tend to lead exports have stopped their pace of deceleration. It is still too early to read much into this data, since it could be a reflection of re-stocking ahead of possible tariffs. That said, data out of Singapore has been a timely tracker of global trade and warrants monitoring (Chart I-3). Chart I-3ASigns Of Life Along Shipping Lanes Signs Of Life Along Shipping Lanes Signs Of Life Along Shipping Lanes Chart I-3BWatch Activity At Singaporean Ports Watch Activity At Singaporean Ports Watch Activity At Singaporean Ports Chinese money growth, especially forward-looking liquidity indicators such as M2 relative to GDP, has bottomed. Historically, this has lit a fire under cyclical stocks, and by extension pro-cyclical currencies. This is also consistent with the fall in Chinese bond yields that has historically tended to be supportive for money growth in the ensuing months (Chart I-4). Overall industrial production remains weak, but the production of electricity and steel, inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role. Overall residential property sales remain soft, but the evidence from tier-1 and even tier-2 cities is that this may be behind us. A revival in the property market will support construction activity, investment and imports (Chart I-5). Chart I-4A Bullish Signal For Chinese Liquidity A Bullish Signal For Chinese Liquidity A Bullish Signal For Chinese Liquidity Chart I-5 Finally, high-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD have stopped falling and are off their lows of the year. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming more favorable to carry trades. The message so far is that the drop in U.S. bond yields may have been sufficient to make these currencies attractive again (Chart I-6). On a similar note, if currencies in emerging Asia that sit closer to the epicenter of Chinese stimulus can rally from here, it would indicate that policy stimulus is sufficient, and that the transmission mechanism is working. Chart I-6High-Beta Currencies Have Stopped Falling High-Beta Currencies Have Stopped Falling High-Beta Currencies Have Stopped Falling Chart I-7AUD/JPY Near A Critical Level AUD/JPY Near A Critical Level AUD/JPY Near A Critical Level Importantly, the AUD/JPY cross is sitting at an important technical level. Ever since the financial crisis, 72.5 has proven to be formidable intra-day resistance, with the cross failing to break below both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. Speculators are neutral on the cross, suggesting any move in either direction could be powerful and significant. A break below will signal we are entering a deflationary bust. A bounce could be a prologue to a reflationary rally (Chart I-7). Bottom Line: We are watching a few key reflationary indicators to gauge whether it pays to be contrarian. The message is tipping in favor of pro-cyclical currencies, and further improvement will give us the green light to adopt a more pro-cyclical stance.  The Message From The U.S. Dollar The market interpreted the Fed’s latest monetary policy announcement as dovish, even though the central bank kept rates on hold. What transpired during the conference was the market increasing its bets for more aggressive rate cuts. The swaps market is currently pricing in 94 basis points of rate cuts over the next 12 months, versus 76 basis points a fortnight ago. This shift has pushed down the dollar, lifting other currencies and gold in the process. U.S. bond yields have also punched below 2%. Interest rate differentials are moving against the dollar, but our important takeaway – that gold continues to outperform Treasurys – is an ominous sign. Even before the financial crisis, a long-standing benchmark for gauging ultimate downside in the dollar was the bond-to-gold ratio. This is because gold has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick for tick. Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the bond-to-gold ratio. Chart I-8Major Peak In The Bond-To-Gold Ratio? Major Peak In The Bond-To-Gold Ratio? Major Peak In The Bond-To-Gold Ratio? The rationale is pretty simple. Investors who are worried about U.S. twin deficits and the crowded trade of being long Treasurys will shift into gold, since pretty much every other major bond market (Germany, Switzerland, Japan) have negative yields. That favors gold at the expense of the dollar. The reverse is true if investors consider Treasurys more of a safe haven. The bond-to-gold ratio and dollar tend to move tick for tick, so a breakout in one can be a signal for what will happen to the other. This is why we are watching this ratio like hawks, and the breakdown this week is a bad omen for the U.S. dollar (Chart I-8). The euro might be the biggest beneficiary from the fall in the dollar. The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others such as Spain and Italy.1 As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The silver lining is that the ECB may now have finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries: 10-year government bond yields in France, Spain, Portugal and even Italy now sit close to or below the neutral rate (Chart I-9). The ECB may now have finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries. Chart I-9The ECB May Have Won The Euro Battle The ECB May Have Won The Euro Battle The ECB May Have Won The Euro Battle The drop in the euro since 2018 has also eased financial conditions and made euro zone companies more competitive. This is a tailwind for European stocks. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts began aggressively revising up their earnings estimates for euro zone equities earlier this year, relative to the U.S. If they are right, this could lead into powerful inflows into the euro over the next nine to 12 months (Chart I-10).  Chart I-10The Euro May Be On The Verge Of A Major Pop The Euro May Be On The Verge Of A Major Pop The Euro May Be On The Verge Of A Major Pop Bottom Line: Falling rate expectations relative to policy action have historically been bearish for the dollar with a lag of about nine to 12 months. The dollar has been relatively resilient, despite interest rate differentials are moving against it, but has started to converge towards lower rates. One winner will be EUR/USD. Stay Short USD/JPY The BoJ kept monetary policy on hold this week, but the message was cautious, even encouraging fiscal support. It looks like the end of the Heisei era2 has brought forward a well-known quandary for the central bank, which is that additional monetary policy options are hard to come by, since there have been diminishing economic returns to additional stimulus. This puts short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Chart I-11Stealth Tapering By The BoJ Stealth Tapering By The BoJ Stealth Tapering By The BoJ The BoJ maintained Yield Curve Control (YCC), stating it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”3 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs and almost 5% of JREITs, this will be a tall order (Chart I-11). The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon, given bond yields closing in on the -20 basis-point floor. This means interest rate differentials are likely to move in favor of a stronger yen short term (Chart I-12). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. The overarching theme for prices in Japan is a rapidly falling (and ageing) population leading to deficient demand. More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI, making it very difficult for the BoJ to re-anchor inflation expectations upward. The risk to short USD/JPY positions is that the BoJ will eventually act, but it may first require a riot point. On the other side of the coin, YCC and negative interest rates have been an anathema for Japanese net interest margins and share prices. This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over.  Chart I-12Can Japan Drop Rates Further? Can Japan Drop Rates Further? Can Japan Drop Rates Further? Chart I-13MMT Might Be What The Doctor Ordered MMT Might Be What The Doctor Ordered MMT Might Be What The Doctor Ordered Bottom Line: Inflation expectations remain at rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The risk to short USD/JPY positions is that the BoJ will eventually act, but it may first require a riot point (Chart I-13). A Final Note On The Pound A new conservative leadership is at the margin more negative for the pound (the assessment of our geopolitical strategists is that the odds of a hard Brexit have risen from 14% to 21%). However, our simple observation is that the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union (Chart I-14). Chart I-14Support For Brexit Is Low, But Has Risen Support For Brexit Is Low, But Has Risen Support For Brexit Is Low, But Has Risen Chart I-15Low Rates Could Help British Capex Low Rates Could Help British Capex Low Rates Could Help British Capex   The BoE kept rates on hold following its latest policy meeting and will continue to err on the side of caution until the Brexit imbroglio is resolved. The reality is that the pound and U.K. gilt yields should be much higher solely on the basis of hard incoming data. Yes, the data has softened, but employment growth has been holding up very well, wages are inflecting higher and the average U.K. consumer appears in decent shape. Investment and construction have been the weak spot in the U.K. economy but may marginally improve on low rates (Chart I-15). We remain long the pound, given lower overall odds of a no-deal Brexit. That said, our long GBP/USD position was a few pips from being stopped out this week. Stand aside if triggered. Housekeeping Our stop-loss on long EUR/CHF was triggered at 1.11 yesterday. Stand aside for now, but we will be looking for opportunities to put this trade back on. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Weekly Report, titled “EUR/USD And The Neutral Rate Of Interest,” dated June 14, 2019, available at fes.bcaresearch.com. 2 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 1989 until his abdication on 30 April 2019. 3  Please refer to the Bank of Japan “Minutes of The Monetary Policy Meeting,” dated June 20, 2019, page 1. 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 mostly negative: Retail sales grew by 0.5% month-on-month in May. University of Michigan consumer sentiment and expectation indices both fell to 97.9 and 88.6 in June. However, current conditions index increased to 112.5. NY empire state manufacturing index came in at -8.6 in June, falling below 0 for the first time since October 2016. NAHB housing market index fell to 64 in June. Housing starts contracted by 0.9% month-on-month in May, while building permits increased by 0.3% month-on-month. Current account deficit decreased to $130.4 billion in Q1. Philadelphia Fed Business Outlook survey index fell to 0.3 in June. DXY index fell by 1% this week. This Wednesday, the Fed has kept interest rates steady at 2.5%, but left the door open for rate cuts in the future as Powell stated that “Many participants now see the case for somewhat more accommodative policy has strengthened.” The dollar has weakened in response to the dovish pivot. Report Links: EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 President Trump And The Dollar - May 9, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative with muted inflation: Trade surplus narrowed to €15.3 billion in April. Headline and core inflation fell to 1.2% and 0.8% year-on-year respectively in May. ZEW survey expectations index fell to -20.2 in June. Current account surplus decreased to €20.9 billion in April. Construction output growth fell to 3.9% year-on-year in April. Consumer confidence fell further to -7.2 in June.  EUR/USD increased by 0.7% this week. The cross fell initially on Draghi’s dovish message that ECB would ease policy again should inflation fail to accelerate, then rebounded on broad dollar weakness this Wednesday following the Fed’s dovish pivot. However, the euro has weakened further against other currency pairs. Our EUR/CHF trade was stopped out at 1.11 on Thursday morning. Report Links: EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 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 mostly negative: Industrial production was unchanged at -1.1% year-on-year in April. Total adjusted trade balance decreased to -¥609.1 billion in May. Imports fell by 1.5% year-on-year, while exports contracted by 7.8% year-on-year. All industry activity index increased by 0.9% month-on-month in April. Machine tool orders continued to contract by 27.3% year-on-year in May. USD/JPY fell by 1.1% this week. BoJ kept the interest rate unchanged at -0.1% this week. In the monetary statement, the BoJ stated that the Japanese economy would likely continue expanding at a moderate rate, despite exogenous shocks. The current policy rates will be maintained at least through the spring of 2020. Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mixed: Retail price index increased by 3% year-on-year in May. Headline and core inflation fell to 2% and 1.7% year-on-year respectively in May. Total retail sales growth fell to 2.3% year-on-year in May. GBP/USD increased by 0.9% this week. The MPC voted unanimously to keep the interest rate unchanged at 0.75% this week. However, some policymakers have suggested that borrowing costs should be higher. The BoE however cut its growth forecast in the second quarter of 2019 amid rising global trade tensions and a fear of “no-deal” Brexit. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 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 There is little data from Australia this week: House price index contracted by 7.4% year-on-year in Q1. Westpac leading index fell by 0.08% month-on-month in May. AUD/USD rose by 0.7% this week. Our long AUD/USD came close to the stop-loss at 0.68 this Tuesday, then rebounded on dollar weakness and is now trading around 0.69. RBA governor Philip Lowe said that it was unrealistic to think that the single quarter-point cut to 1.25% would work to achieve its growth target, signaling more rate cuts and fiscal stimulus in the future. We are holding on to the long AUD/USD position from a contrarian perspective, and believe that the Aussie dollar will benefit as a pro-cyclical currency if the global growth outlook turns positive. 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 mixed: REINZ house sales keep contracting by 7.8% year-on-year in May. Business Manufacturing PMI fell to 50.2 in May.  Westpac consumer confidence fell to 103.5 in Q2. Current account surplus widened to N$0.675 billion in Q1. GDP growth was unchanged at 0.6% in Q1 on a quarter-on-quarter basis. However, it increased to 2.5% on a year-on-year basis.  NZD/USD increased by 1.1% this week. Our bias remains that the New Zealand dollar has less room to rise compared to other pro-cyclical currencies if global growth picks up. Our SEK/NZD position is 1.3% in the money since initiated. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mixed: Foreign portfolio investment in Canadian securities fell by C$12.8 billion in April. Bloomberg Nanos confidence increased to 56.9 in June. Manufacturing sales fell by 0.6% month-on-month in April. Headline and core inflation both increased to 2.4% and 2.1% year-on-year respectively in May, surprising to the upside. USD/CAD fell by 1.6% this week. The surprising Canadian inflation print, and oil price recovery are all underpinning the Canadian dollar in the short term. This Thursday, Iran shot down a the U.S. drone in Gulf, and fears have been rising of a military confrontation between the U.S. and Iran, which is bullish for oil prices and the Canadian dollar. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 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: Exports and imports increased to CHF 21.5 billion and CHF 18.1 billion respectively in May, resulting in a higher trade surplus of CHF 3.4 billion. USD/CHF fell by 1.7% this week. The Swiss franc has strengthened significantly against the U.S. dollar and the euro following the more-than-expected dovish shifts by the ECB and the Fed this week. Our bias remains that the SNB will use the currency as a weapon to defend the economy. 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 negative: The trade surplus narrowed to 11.3 billion NOK in May. USD/NOK fell by 1.6% this week. The Norges bank raised interest rates from 1% to 1.25%, the third rate hike during the past 12 months, and the Bank is also signaling more to come in the future. The Norges Bank remains the only hawkish central bank among all the G10 countries at this moment. The widening interest rate differentials and bullish oil outlook have been pushing the Norwegian krone higher. Our long NOK/SEK position is now 4.5% in the money. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 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 neutral: Headline and core inflation increased to 2.2% and 2.1 year-on-year respectively in May. Consumer confidence increased to 93.8 in June, while manufacturing confidence fell to 100.2. Unemployment rate increased to 6.8% in May. USD/SEK fell by 0.7% this week. Easing financial conditions worldwide remain a tailwind for global growth. Risk assets are rebounding with higher hopes of a trade deal as Trump will meet Xi at the G20 summit. We believe that the Swedish krona will benefit if global growth picks up in the second half of this year. 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 Closed Trades

Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Risk-On Indicators Breaking Down? Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed Global Sentiment Remains Depressed Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Fiscal Pullback Likely Next Year Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Only The U.S. Is Profligate Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems.  Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War Stimulus Amid The Trade War Stimulus Amid The Trade War Chart 5 The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). Chart 6 China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Chart 7 Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Chart Chart 8 Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz Escalation ... Everywhere Escalation ... Everywhere A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). Chart 9 We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? Is The 'Pivot To Asia' About To Reverse? Is The 'Pivot To Asia' About To Reverse? Chart 11 The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal Escalation ... Everywhere Escalation ... Everywhere This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree Escalation ... Everywhere Escalation ... Everywhere At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Crude Oil Supply-Demand Balance Should Send Prices Higher Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Chart 13 Chart 14 Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. Chart 15 The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). Chart 16 We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Chart 17 Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. Chart 18 We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Hard To Win The Senate In 2020 While Key States Prosper Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Escalation ... Everywhere Escalation ... Everywhere Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Image

Highlights As long as the global long bond yield stays near 2 percent or below, European equities will end the year at broadly the same level as now… …but they will experience a dip of at least 4-5 percent along the way. All central banks have pivoted to dovish but the Fed has more easing armoury than the ECB. This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. Feature At the start of this year we explained Why 2019 Is A Pivotal Year For Monetary Policy. Today we want to elaborate on that report, and its key observations: Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to tightening emanates from the hyper-sensitivity of financial conditions to rate hikes, rather than from the direct impact on rate-sensitive sectors in the economy. Since October 2017, no stock market rally or sell-off has lasted more than three months or so (Chart Of The Week). These observations are as relevant – or more relevant – now, as they were at the time of our original report.1 Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent. Chart Of The WeekSince 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 A 2 Percent Tightening Is The Post-2008 Limit Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before having to reverse course (Chart I-2 and Chart I-3). Chart I-2A 2 Percent Sequential Tightening Is The Post-2008 Limit A 2 Percent Sequential Tightening Is The Post-2008 Limit A 2 Percent Sequential Tightening Is The Post-2008 Limit Chart I-3A 2 Percent Sequential Tightening Is The Post-2008 Limit A 2 Percent Sequential Tightening Is The Post-2008 Limit A 2 Percent Sequential Tightening Is The Post-2008 Limit     In 2008, Swedish interest rates peaked near 5 percent before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Though admittedly, both Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. However, on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening also of only 1 percent; Korea could manage just 1.25 percent; the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. The Federal Reserve raised interest rates sequentially by 2 percent through December 2016 to December 2018, and guess what – it is now on the cusp of reversing course. The ultimate course will have a huge bearing on investment strategy for European equities, bonds and currencies. The Neutral Real Rate Of Interest Is Zero Many economists and strategists expected the Fed to continue hiking through 2019, but this publication pushed back hard. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. Central to this publication’s resistance was, and is, a high-conviction view that the so-called ‘neutral’ real rate of interest – the real interest rate that is neither accommodative nor restrictive, the real interest rate consistent with an economy maintaining full employment while keeping inflation constant – is zero. The neutral rate of interest is very low. In our Special Report Why The Neutral Rate Of Interest Is Zero we proposed that the neutral rate is global rather than region-specific, that it refers to the bond yield rather than to the policy rate, and that it is extremely low. As it happens, the Fed broadly concurs. With the policy rate, bond yield, and inflation all at around 2 percent, the real policy rate and real bond yield are both near zero. At this level the central bank claims that “the policy stance is now in the Committee’s estimates of neutral… and when you get to that range we have to let the data speak to us.”2  Chart I-4 However, the data that is speaking most loudly is not necessarily the economic data, it is the financial market data. Jay Powell has said that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” We think it has (Chart I-4). Comparing Today’s Rich Valuations With 2007 In the aftermath of the dot com bubble burst in 2000, policy interest rates collapsed to very low levels but, crucially, long bond yields did not. This contrasts with the aftermath of the Global Financial Crisis in 2008, during which both policy interest rates and bond yields have plunged to all-time lows (Charts I-5 - I-7). Funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. Chart I-5In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did Chart I-6In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did   Chart I-7In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did The difference between the post-2000 and post-2008 policy responses can be summarized in two letters: QE. For all its apparent complexity, QE is actually a very simple monetary policy tool. It is just a mechanism for signalling that the policy interest rate will remain low for an extended period. Thereby, QE pulls down the long-term interest rate, which is to say the long bond yield. The double-digit rally over the past six months is technically extended. But as we have consistently pointed out on these pages, funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. We refer readers to our other reports for the details, but in a nutshell the risk of owning bonds converges to the risk of owning equities and other so-called ‘risk-assets’. The upshot of this risk convergence is that investors price these risk-assets to deliver the same ultra-low nominal return as bonds, meaning that the valuation of the risk-assets soars.3   Chart I-8Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent All of which brings us to the crucial point. The post-2000 extreme policy easing distorted the real economy. It engineered a credit boom. So the fragility to the subsequent policy tightening emanated from the real economy, and particularly the most rate-sensitive sectors in the economy such as mortgage lending and housing. In contrast, the post-2008 extreme policy easing – driven by QE – has distorted the valuation of risk-assets. Moreover, the value of global risk-assets, at $400 trillion dwarfs the $80 trillion global economy by five to one. So the current fragility to policy tightening does not emanate from the real economy, it emanates from the hyper-sensitivity of financial conditions to higher bond yields (Chart 8). Some European Investment Implications The integration of global capital markets means that the valuation anchor for European – and all regional – stock markets now comes from the global long bond yield, which we define as the simple average of the 10-year yields in the euro area, U.S., and China. Through the past five years, the inability of the global long bond yield to remain above 2.5 percent confirms the hyper-sensitivity of financial conditions to higher interest rates. And it suggests that the ‘neutral’ rate on this measure is around 2 percent. The good news is that this measure now stands slightly below neutral at 1.9 percent. The euro has a sound structural underpinning versus the dollar. At around this level of the global long bond yield, the rich valuation of European equities has some support. That said, the double-digit rally over the past six months is technically extended, as most of the things that could go right did go right – central banks pivoted to dovish, euro area growth rebounded, and, until recently, geopolitical risks were easing. Hence, as long as the global long bond yield stays near 2 percent or below, we expect European equities to end the year at broadly the same level as now, though our technical signals do strongly suggest a dip of at least 4-5 percent along the way (Chart I-9). Chart I-9The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended Chart I-10The Fed Has More Easing Armoury Than The ECB The Fed Has More Easing Armoury Than The ECB The Fed Has More Easing Armoury Than The ECB As regards bonds and currencies, all central banks have pivoted to dovish but the Fed has more easing armoury than the ECB (Chart I-10). This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. However, this structural underpinning also applies to the yen, and until we get some clarity on Brexit we prefer the yen over the euro.   Fractal Trading System* In line with the main body of this report and Chart 9, we see evidence that the double-digit rally in stock markets over the past six months is technically extended. Accordingly, this week’s recommended trade is to short the MSCI All-Country World index, setting the profit target at 4 percent with a symmetrical stop-loss. This leaves us with four open positions.  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. Global Financial Services Vs. Market Global Financial Services Vs. Market *      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      Please see the European Investment Strategy Weekly Report ‘Why 2019 Is A Pivotal Year For Monetary Policy’ February 7, 2019 available at eis.bcaresearch.com. 2      Please see the European Investment Strategy Special Report ‘Why The Neutral Rate Of Interest Is Zero’ June 6, 2019 available at eis.bcaresearch.com. 3      Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.bcaresearch.com. 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