Europe

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of our country Monitors are now forecasting monetary policy on hold, apart from Australia and New Zealand where looser policy is warranted (Chart of the Week). However, with early leading indicators now flagging a trough in global growth, and with labor markets mostly tight, the Monitors may not signal a need for incremental easing since inflationary pressures have not decelerated much. Given how far global bond yields have fallen in response to the weaker growth backdrop over the past year, any sign of the Monitors finding a floor would herald a turnaround in overbought global government bond markets – most notably in the U.S. and core Europe, where a below-benchmark strategic duration stance is most appropriate. Feature Chart of the WeekA Synchronized Pullback In The BCA Central Bank Monitors A Synchronized Pullback In The BCA Central Bank Monitors A Synchronized Pullback In The BCA Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Bond Yields Have Fully Adjusted To Our CB Monitors Bond Yields Have Fully Adjusted To Our CB Monitors Bond Yields Have Fully Adjusted To Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocations for global government bonds reflect the trends seen in the Central Bank Monitors, even as they have all shifted lower. We are favoring countries where the Monitors are falling (Australia, the U.K., Japan, New Zealand and Canada) relative to regions where the Monitors appear to be stabilizing (the U.S., core Europe). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against money market yields curves (the spread between 1-year government bond yields and central bank policy rates, to measure expected changes in interest rates). Fed Monitor: No Rate Cuts Needed Our Fed Monitor has drifted lower over the past several months and now sits just above the zero line (Chart 3A). That indicates no pressure to hike interest rates, which is consistent with the Fed’s recent dovish turn. Yet the Monitor is also not yet in the “easier money required” zone that would suggest a need for the Fed to lower the funds rate - even though that is an outcome now discounted in the U.S. yield curve. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Yes, the U.S. has finally seen some negative impact from slower global growth and the late-2018 tightening of U.S. financial conditions. However, those factors are now starting to become less negative for growth – most notably the across-the-board rally in equity and credit markets in Q1 that has eased financial conditions. There is little danger of a shift to a sustained period of below-trend growth (i.e. less than 2%) in 2019 that would free up spare capacity, and ease inflation pressures, in the U.S. economy (Chart 3B).   Chart 3AU.S. Treasury Rally Looks Overdone U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BA Big Pullback In U.S. Inflation Is Unlikely A Big Pullback In U.S. Inflation Is Unlikely A Big Pullback In U.S. Inflation Is Unlikely Among the three sub-components of the Fed Monitor (growth, inflation and financial conditions), all are close to the zero lines (Chart 3C), suggesting that the current neutral signal from the Monitor is broad-based. The rally in the U.S. Treasury market now looks stretched, however, with the 10-year yield now lower than levels of a year ago – an outcome that, in that past, has usually coincided with the Fed Monitor falling well below zero (Chart 3D). A below-benchmark duration stance in the U.S. is appropriate, as the risk/reward profile favors higher Treasury yields from current depressed levels. Chart 3CFed Monitor Components All Near Zero, Validating Current Fed Pause Fed Monitor Components All Near Zero, Validating Current Fed Pause Fed Monitor Components All Near Zero, Validating Current Fed Pause Chart 3DU.S. Treasury Rally Looks Overdone U.S. Treasury Rally Looks Overdone U.S. Treasury Rally Looks Overdone BoE Monitor: The Window For A Rate Hike Has Closed Our Bank of England (BoE) Monitor, which had been in the “tighter money required” zone between 2016-18, has fallen back to the zero line (Chart 4A). The obvious culprit is the ongoing Brexit uncertainty, which has damaged confidence among both businesses and consumers. Overall economic growth has held in better than expected given the Brexit noise – for example, the manufacturing PMI now sits at 55.1, comfortably above the boom/bust 50 threshold. Yet leading economic indicators continue to deteriorate and growth is likely to remain under downward pressure in the coming months. Despite estimates showing a lack of spare capacity in the U.K. economy (a closed output gap, an unemployment rate well below NAIRU), both headline and core inflation have fallen back to the BoE’s 2% target (Chart 4B). The central bank has changed its policy bias as a result, with even the more hawkish members of the Monetary Policy Committee signaling that there is no longer any pressing need for rate hikes.   Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BU.K. Inflation Back To BoE Target U.K. Inflation Back To BoE Target U.K. Inflation Back To BoE Target When looking at the split between the growth and inflation components of our BoE Monitor, it is clear that the former has triggered the large fall in the Monitor (Chart 4C). Yet even the inflation component has fallen below the zero line. With no pressure from any corner to alter monetary policy, the BoE can continue to sit on its hands and wait for some clarity to develop on the Brexit front. Chart 4CHit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold Hit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold Hit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold We continue to recommend overweighting U.K. Gilts within global government bond portfolios, given the weakening trend in U.K. leading economic indicators and persistent Brexit uncertainty (Chart 4D). Chart 4DA Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields A Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields A Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields ECB Monitor: Bund Yields Have Fallen Too Far Our European Central Bank (ECB) Monitor is slightly below the zero line, signaling no real need for any change to euro area monetary policy (Chart 5A). The sharp slowing of economic growth last year, driven primarily by plunging exports, is the main reason why the Monitor has stayed subdued. Despite the weaker growth momentum, however, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Inflation More Stable At Full Employment Euro Area Inflation More Stable At Full Employment Euro Area Inflation More Stable At Full Employment   Nonetheless, the ECB has already back-pedaled on policy normalization announced last December. The central bank announced a new program of cheap funding for euro area banks (TLTRO3) to begin this September, replacing the expiring loans from the previous funding program. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor. There are some tentative signs that euro area growth may be stabilizing, such as increases in the expectations component of the ZEW and IFO surveys. If this is the beginning of a true cyclical turnaround, then the downward pressure on our ECB Monitor from a weak economy will soon reverse (Chart 5C). Chart 5COffsetting Growth & Inflation Components In The ECB Monitor Offsetting Growth & Inflation Components In The ECB Monitor Offsetting Growth & Inflation Components In The ECB Monitor The ECB is now signaling that it will keep policy rates unchanged until the end of the year, on top of the new TLTRO. In addition, faster global growth in the latter half of 2019 will provide a boost to the euro area economy via the export channel. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor (Chart 5D). We recommend only a neutral allocation to core European government bonds, but our next move is likely a downgrade. Chart 5DBund Rally Looks Stretched Versus ECB Monitor Bund Rally Looks Stretched Versus ECB Monitor Bund Rally Looks Stretched Versus ECB Monitor BoJ Monitor: No Inflation, No Change In Policy Our Bank of Japan (BoJ) Monitor has drifted back to the zero line after a brief cyclical stay in the “tighter money required” zone in 2017/18 (Chart 6A). Such is life in Japan, where even an unemployment rate of 2.3% – the lowest in decades – cannot generate inflation outcomes anywhere close to the BoJ’s 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation The slowing of global trade activity and weakness in Chinese economic growth has hit the export-sensitive Japanese economy hard. Industrial production is now contracting, export volumes fell –6.8% year-over-year in January, and the widely-followed Tankan survey showed the biggest quarterly drop in business confidence among manufacturers in Q1/2019 since 2011. Household confidence has also taken a hit and retail sales growth has stagnated. Against such a weak economic backdrop, the soft growth component of our BoJ Monitor is fully offsetting the relative strength of the inflation component (Chart 6C). The latter is mostly related to the tightness of Japan’s labor market, which has pushed nominal wage inflation to 3.0% - the fastest pace since 1990. Core inflation at 0.4% has not followed suit, however. Chart 6CStill Not Enough Growth To Justify Any Reduction in BoJ Accommodation Still Not Enough Growth To Justify Any Reduction in BoJ Accommodation Still Not Enough Growth To Justify Any Reduction in BoJ Accommodation We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings – especially compared to the rest of the developed markets – until there is much higher realized core inflation in Japan. There is no chance of the BoJ moving any part of the Japanese yield curve it effectively controls (all interest rates with maturity of 10 years of less) until both growth and inflation move durably higher (Chart 6D). Chart 6DNo Pressure On JGB Yields To Rise No Pressure On JGB Yields To Rise No Pressure On JGB Yields To Rise BoC Monitor: Neutral Across The Board Our Bank of Canada (BoC) Monitor has fallen sharply since mid-2018 and now sits right at the zero line, suggesting no pressure to change monetary policy (Chart 7A). The main cause is weakness in the Canadian economy, which has responded negatively to the combination of previous BoC rate hikes, diminished business confidence and slower global growth. The central bank was surprised by how rapidly the Canadian economy lost momentum at the end of last year, when real GDP expanded an anemic 0.4% annualized pace in Q4/2018. That prompted the BoC to signal a halt to the rate hikes, even with core inflation measures hovering close to the midpoint of the BoC’s 1-3% target band (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BIs Economic Slack Underestimated In Canada? Is Economic Slack Underestimated In Canada? Is Economic Slack Underestimated In Canada? Canadian money markets now discount -20bps of rate cuts over the next year. In the past, market pricing of BoC rate expectations has tended to be more correlated to the inflation component of our BoC Monitor (Chart 7C). The latest downturn in the Monitor, however, has been driven by declines in both the growth and inflation components. The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7CBoC Monitor Components Both Consistent With No Change In Interest Rates BoC Monitor Components Both Consistent With No Change In Interest Rates BoC Monitor Components Both Consistent With No Change In Interest Rates We closed our long-standing underweight recommended allocation for Canadian government bonds on March 19.1 We are now at neutral weight, although we may shift to an overweight stance if the coming rebound in global growth that we expect does not carry over into the Canadian economy and trigger some stabilization in our BoC Monitor (Chart 7D). The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7DCanadian Yields Will Not Rise Again Without A Rebound In Growth Canadian Yields Will Not Rise Again Without A Rebound In Growth Canadian Yields Will Not Rise Again Without A Rebound In Growth RBA Monitor: More Pressure To Cut Rates The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). A slumping economy has been weighed down by sluggish consumption, weak exports and falling house prices in the major cities. Combined with inflation stubbornly below the 2-3% RBA target band, this has driven Australian bond yields to new lows. -41bps of RBA rate cuts over the next year are now discounted in the Australian OIS curve. Delivering on those rate cut expectations, however, will likely require some weakening of the labor market (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor As depicted in Chart 8C, both the growth and inflation components of our RBA Monitor have fallen below the zero line. Over the past quarter-century, when both components of the RBA Monitor were as far below zero as they are now, shorter-dated bond yields have ended up falling below the Cash Rate as markets move to price in an easing cycle. That 1-year/Cash Rate spread has not yet gone negative, suggesting there is more room for the entire Australian government yield curve to be dragged lower by the front-end if the economy does not soon improve. Chart 8CSoft Inflation Is Why Our RBA Monitor Is Calling For Cuts Soft Inflation Is Why Our RBA Monitor Is Calling For Cuts Soft Inflation Is Why Our RBA Monitor Is Calling For Cuts The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive. The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive (Chart 8D). With Australia’s leading economic indicator still decelerating, and with any boost to exports not likely until later this year, we continue to recommend an overweight stance on Australian government bonds. Chart 8DStay Long Australian Bonds Stay Long Australian Bonds Stay Long Australian Bonds RBNZ Monitor: Setting Up For A Rate Cut Our Reserve Bank of New Zealand (RBNZ) monitor has been below the zero line since September 2018, indicating that easier monetary policy is required. (Chart 9A). The central bank made a significant dovish shift in its forward guidance at the March meeting, noting that the balance of risks for the New Zealand (NZ) economy was now tilted to the downside and the next move is more likely to be a rate cut. That dovish turn is consistent with the underwhelming performance of NZ inflation (Chart 9B). The RBNZ does not expect inflation to hit 2% until the end of 2020, even with the unemployment rate at a ten-year low of 4.3% and wages growing at a 2.9% annual rate. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Has Struggled To Breach 2% NZ Inflation Has Struggled To Breach 2% NZ Inflation Has Struggled To Breach 2% Over the past two decades, market pricing of RBNZ rate moves has been more correlated to the growth component of our RBNZ Monitor. In the years since the Global Financial Crisis, however, the growth and inflation components have been highly correlated to each other and to expectations for interest rates (Chart 9C). With markets now discounting -45bps of rate cuts over the next year, the NZ yield curve appears appropriately priced relative to our RBNZ Monitor. Chart 9CBoth Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts Both Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts Both Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts We have maintained a bullish recommendation on NZ government bonds versus both U.S. Treasuries and German Bunds since mid-2017, and we see no reason to close this highly profitable position, even if the RBNZ fails to fully deliver on discounted rate cuts. Both Treasuries and Bunds look overvalued amid signs of U.S. and European growth stabilizing, while the deterioration in our RBNZ Monitor suggests NZ yields have far less upside (Chart 9D). Chart 9DStay Long New Zealand Government Bonds Stay Long New Zealand Government Bonds Stay Long New Zealand Government Bonds Riksbank Monitor: Rate Hikes Delayed, Rate Cuts Unlikely Our Riksbank Monitor is currently slightly below zero and market is now priced for -17bps of rate cuts over next year (Chart 10A). The market has judged that the recent bout of weaker Swedish economic data has effectively derailed the Riksbank’s plans to hike rates in the second half of 2019. However, given the dearth of spare capacity in the Swedish economy (Chart 10B), and with the policy rate still negative, rate cuts are unlikely to be delivered. At best, the central bank can delay rate hikes if growth continues to disappoint, which also supports easier monetary conditions via a weaker exchange rate (the krona is down -4.7% year-to-date). Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Inflation Cooling Off A Bit Sweden Inflation Cooling Off A Bit Sweden Inflation Cooling Off A Bit The Riksbank stated in its February Monetary Policy Report that low Swedish productivity growth is leading to cost pressures through higher unit labor costs. It also forecasts that faster wage growth over the next year will help keep inflation near the 2% Riksbank target. The implication is that it will take much weaker growth, and higher unemployment, before the central bank will completely abandon its quest to normalize Swedish interest rates. The relationship between the growth/inflation components of our Riksbank Monitor and the market’s interest rate expectations has been weak since the central bank cut rates below zero and introduced quantitative easing in late 2014 (Chart 10C). Prior to that, however, it was the growth component that was more correlated to short-term interest rate expectations. On that note, the rebound in global growth that we are expecting will help support the Swedish economy, which is highly geared to global economic activity, and put a floor under Swedish bond yields (Chart 10D). Chart 10CRiksbank Can Stay On Hold Riksbank Can Stay On Hold Riksbank Can Stay On Hold Chart 10DNo Pressure For Higher Sweden Bond Yields No Pressure For Higher Sweden Bond Yields No Pressure For Higher Sweden Bond Yields Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see Global Fixed Income Weekly Report “March Calmness,” published March 19, 2019. Available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Validating The Dovish Turn BCA Central Bank Monitor Chartbook: Validating The Dovish Turn Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Quarterly - April 2019 Quarterly - April 2019 Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Market Doesn't Believe The Fed's Target Market Doesn't Believe The Fed's Target Table 1Fed Won’t Be Able To Cut This Much Next Time Quarterly - April 2019 Quarterly - April 2019   Chart 2Financial Conditions Now Much Easier Financial Conditions Now Much Easier Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Housing Market Bottoming Out Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth Some "Green Shoots" For Global Growth Some "Green Shoots" For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Fed Still Below Neutral Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus Ex US Equities Driven By China Stimilus Ex US Equities Driven By China Stimilus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Oil, Positioning, And Housing Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Declining Quality In Investment Grade Declining Quality In Investment Grade Chart 11 Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound? A Value Rebound A Value Rebound Chart 14   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Watch Earnings Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Warming Up To The Euro Area Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Becoming Less Defensive Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Rates: Likely More Upside Risk Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers Favor Inflation Linkers Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit Tactical Upside Remains For Credit Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Prefer Oil, Watch Metals Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market The End Of The Dollar Bull Market The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Yield Curve Inversion Yield Curve Inversion Chart 27How Much Is China Reflating? How Much Is China Reflating? How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Highlights Global equities and other risk assets will trade sideways with elevated volatility over the coming weeks before grinding higher for the remainder of the year, as global growth finally accelerates after a series of false starts.  We now see the Fed raising rates more slowly than we had previously envisioned, but ultimately having to scramble to hike rates in order to quell inflation. The fed funds rate will probably plateau at 4% in 2021, implying nine quarter-point hikes more than the market is currently discounting.   Over a 12-month horizon, investors should overweight global equities, underweight government bonds, and maintain a neutral allocation to cash. The dollar will peak in the second quarter and then weaken over the remainder of the year and into 2020, before starting to strengthen again late next year. Investors should prepare to temporarily upgrade EM and European stocks over the coming weeks, while increasing exposure to cyclical equity sectors. Industrial metals and oil will strengthen over the course of the year. Gold should be bought on any dip. Investors should begin to de-risk their portfolios in late-2020 in anticipation of a recession in 2021. Chart 001   Feature Here We Go Again? After having become more defensive last June, we turned bullish on stocks following the December post-FOMC meeting plunge. As stocks continued to rebound, we tempered our optimism. In the beginning of March, we wrote that “having rallied since the start of the year, global stocks will likely enter a ‘dead zone’ over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout.”1 Last Friday’s release of disappointing European PMI data poured some herbicide on the green shoots thesis. Germany’s manufacturing PMI hit a six-year low, with the new orders component registering the weakest reading since the Great Recession. This took the 10-year German bund yield into negative territory for the first time since 2016. The U.S. 10-year Treasury yield also fell to a 15-month low, causing the 3-month/10-year curve to invert. Historically, an inverted yield curve has been a reliable predictor of U.S. recessions (Chart 1). Chart 1Yield Curve Inversions, Recessions, And The Term Premium Yield Curve Inversions, Recessions, And The Term Premium Yield Curve Inversions, Recessions, And The Term Premium President Trump’s decision to appoint TV commentator Stephen Moore to the Fed’s Board of Governors did not help matters. Recommended by fellow supply-side “economist” Larry Kudlow, Moore is best known for dismissing concerns over the state of the housing market in 2007, his spot-on 2010 prediction that QE would cause hyperinflation, and his belief that the Trump tax cuts would lead to a smaller budget deficit. Global Growth Will Accelerate In The Second Half Of The Year Given all these worrisome developments, is it time to turn cyclically bearish on the economic outlook and risk assets again? We do not think so. While the next few weeks could be challenging for equities – a risk that our MacroQuant model is currently flagging – sentiment should improve as global growth finally accelerates after a series of false starts.  Indeed, some positive signs are already visible: The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has moved higher (Chart 2). It leads the global LEI. Service sector PMIs have also generally improved, suggesting that the weakness in global growth remains concentrated in trade and manufacturing. And even on the trade front, a few forward-looking indicators such as the Baltic Dry Index and the weekly Harpex shipping index, which measures global container shipping activity, have bounced off their lows. We would downplay the signal from the yield curve, as it currently is severely distorted by a negative term premium. If the 10-year Treasury term premium were back to where it was in 2004, the 3-month/10-year slope would be more than 200 bps steeper, and nobody would be talking about this issue. In fact, given today’s term premium, the curve would have almost certainly inverted in 1995. Anyone who got out of stocks back then would have missed out on one of the greatest bull markets in history. It should also go without saying that some of the decline in the U.S. 10-year yield reflects a positive development: The Fed has turned more dovish! If one looks at the 10-year/30-year portion of the yield curve, it has actually steepened. This is a sign that the market is seeing the Fed’s actions as being reflationary in nature. There is no clear causal mechanism by which an inverted yield curve slows economic activity, apart from it potentially becoming a self-fulfilling prophecy where the yield-curve inversion scares investors, thereby leading to a tightening in financial conditions (Chart 3). Such “doom loops” are conceptually possible, but as we discussed earlier this year, they are unlikely to occur in the current environment.2 At any rate, financial conditions have eased since the start of the year. This should boost growth in the coming months.   Chart 2Global Growth May Be ##br##Starting To Stabilize Global Growth May Be Starting To Stabilize Global Growth May Be Starting To Stabilize Chart 3Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Chinese Credit Growth Set To Rise Global growth has been weighed down by a slowing Chinese economy. Last year’s deleveraging campaign led to a significant deceleration in investment spending, which had negative repercussions for capital equipment and commodity producers all over the world (Chart 4). Historically, China has loosened the reins on the financial sector whenever credit growth has fallen towards nominal GDP growth (Chart 5). It appears we have reached this point. Despite a weak seasonally-distorted February print, credit growth has finally accelerated on a year-over-year basis. Chart 4China: The Deleveraging Campaign Had Adverse Effects On Investment Spending China: The Deleveraging Campaign Had Adverse Effects On Investment Spending China: The Deleveraging Campaign Had Adverse Effects On Investment Spending Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth We do not expect Chinese credit growth to rise as much as in past releveraging cycles. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 6).3 As long as the central government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. In any case, given that total debt stands at 240% of GDP, even a one percentage-point increase in credit growth would generate a hefty 2.4% of GDP in credit stimulus. The Chinese credit impulse leads imports by about six-to-nine months (Chart 7). This bodes well for global trade in the second half of the year. Chart 6China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth Chart 7Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse   A Lull In The Trade War? A de-escalation in the trade war would help matters. As a self-professed master negotiator, Donald Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the agreement was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky for Trump if it had failed to bring down the bilateral trade deficit – an entirely likely outcome given how pro-cyclical U.S. fiscal policy is. At this point, however, Trump could crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized only after he has been re-elected. Thus, the likelihood that Trump will seek to strike a deal has risen. For their part, the Chinese want as much negotiating leverage as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Faster Global Growth And Stronger Domestic Demand Will Benefit Europe Stronger Chinese growth will help the European export sector later this year. The export component of the Chinese Caixin PMI has moved up from its lows. It leads the euro area PMI by about three months. Meanwhile, euro area domestic demand will benefit from a more accommodative fiscal policy and lower bond yields. The decline in bond yields will be especially helpful to Italy. The spike in yields and loss of business confidence following the election of a populist government last March plunged the economy into recession (Chart 8). Now that the 10-year BTP yield has fallen more than 100 bps from its highs, the Italian economy should start to perk up. The ECB will not raise rates this year even if domestic growth speeds up, but the market will probably price in a few rate hikes in 2020 and beyond. This will allow for a modest re-steepening of yield curves in core European bond markets, which should be positive for long-suffering bank profits. Brexit remains a concern. The ongoing saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 9), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 8Italian Bond Yields Are A Headwind No More Italian Bond Yields Are A Headwind No More Italian Bond Yields Are A Headwind No More Chart 9U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win   What Will The Fed Do? Chart 10 Last year’s “Christmas Crash” clearly shifted the Fed’s reaction function in a more dovish direction. We do not expect Jay Powell to raise rates over the next few months, but a reacceleration in global growth is likely to prompt the Fed to tighten anew in December. The Fed will continue raising rates once per quarter in 2020, before accelerating the pace of tightening in 2021 in response to rising inflation. In all, we see the fed funds rate increasing to around 4% by the end of this cycle. This represents nine quarter-point hikes more than the market is currently discounting (Chart 10). We were stopped out of our short fed funds futures trade, but we recommend that clients short the June-2021 fed funds futures or a similar instrument. The U.S. Economy: Great Again Fundamentally, the U.S. economy is on solid ground and can handle higher interest rates. Unlike a decade ago, the housing market is in good shape (Chart 11). The homeowner vacancy rate stands near a record low. Judging by FICO scores, the quality of mortgage lending remains high. The labor market is also firm, with job openings hitting another record high in February (Chart 12). The combination of a healthy housing and labor market is invariably good for consumers. Chart 11U.S. Housing Fundamentals Are Solid U.S. Housing Fundamentals Are Solid U.S. Housing Fundamentals Are Solid Chart 12The U.S. Labor Market Is Firm The U.S. Labor Market Is Firm The U.S. Labor Market Is Firm Chart 13 The personal savings rate currently stands at 7.6%, notably higher than one would expect based on the ratio of household net worth-to-disposable income (Chart 13). A decline in the savings rate would allow consumer spending to increase more quickly than income. With the latter being propped up by rising wages, this will be bullish for consumption. Capital spending intentions have dipped over the past few months, but remain elevated by historic standards (Chart 14). The real nonresidential capital stock has grown by an average of only 1.7% since the start of the recovery, down from 3% in the pre-recession period (Chart 15). A cyclical upswing in productivity growth, rising labor costs, and low levels of spare capacity should all motivate businesses to invest in new plant and equipment. Chart 14Capital Spending Intentions Have Softened, But Remain Elevated Capital Spending Intentions Have Softened, But Remain Elevated Capital Spending Intentions Have Softened, But Remain Elevated Chart 15There Is Room For More U.S. Capital Investment There Is Room For More U.S. Capital Investment There Is Room For More U.S. Capital Investment   Corporate Debt: How Much Of A Risk? Chart 16U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards Corporate debt levels have increased significantly in recent years, while underwriting standards have deteriorated, as evidenced by the proliferation of covenant-lite loans. Nevertheless, the situation is far from dire. Relative to other countries, U.S. corporate debt is quite low (Chart 16). At 143% of GDP, corporate debt in France is twice that of the United States. This is not to suggest that everything is fine in the French corporate sector; but the fact is that France has not had a corporate debt crisis. This signals that the U.S. is not at imminent risk of one either. Netting out cash, U.S. corporate debt as a share of GDP is at the same level it was in 1989, a year in which the fed funds rate was close to nine percent. The ratio of corporate net debt-to-EBITD remains reasonably low. The interest coverage ratio is above its historic average. In addition, corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 17). The corporate sector financial balance – the difference between corporate income and spending – is still in positive territory at 1% of GDP. Every recession in the past 50 years began when the corporate sector financial balance was in deficit (Chart 18). Chart 17U.S. Corporate Debt: How High? U.S. Corporate Debt: How High? U.S. Corporate Debt: How High? Chart 18Corporate Sector Financial Balance Still In Surplus Corporate Sector Financial Balance Still In Surplus Corporate Sector Financial Balance Still In Surplus Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players such as pension funds, insurance companies, mutual funds, and ETFs. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 19). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 20). This makes corporate debt less systemically important for the economy.   Chart 19Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Chart 20U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized One of the reasons we turned more bullish on risk assets in December was because stocks had plunged and corporate spreads widened without much follow-through in financial stress indices. For example, the infamous TED spread barely budged (Chart 21). Chart 21TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress Everyone Agrees With Larry Given the lack of major imbalances in the U.S. economy, why do investors believe that the Fed cannot raise rates further even though the Fed funds rate in real terms is barely above zero? The answer is that investors appear to have bought into Larry Summers’ secular stagnation thesis, which posits that the neutral rate of interest is much lower today than it was in the past. We have some sympathy for this thesis, but it is important to remember that it is a theory about the long-term determinants of interest rates such as productivity and demographic trends. The theory says little about the cyclical drivers of interest rates, including the amount of spare capacity in the economy, the stance of fiscal policy, credit growth, and wage trends. Earlier this decade, when we were still very bullish on bonds, one could have plausibly argued that the economy needed extremely low interest rates: The output gap was still large; the deleveraging cycle had just begun; home and equity prices were depressed; wage growth was anemic; and fiscal policy had turned restrictive after a brief burst of stimulus during the Great Recession. Far From Neutral? All of the forces mentioned above have either fully or partially reversed course over the past few years. Take fiscal policy as one example. The IMF estimates that the U.S. structural budget deficit averaged 3.3% of GDP in 2014-15. In 2019-20, the IMF reckons the deficit will average 5.6% of GDP. To what extent has easier fiscal policy raised the U.S. neutral rate of interest? Let us conservatively assume that every $1 of additional fiscal stimulus adds $1 to aggregate demand. In this case, fiscal policy has added 2.3% of GDP to aggregate demand over the past five years. Suppose that a one-percentage point increase in aggregate demand raises the neutral rate of interest by 1%, which is in line with the specification of the Taylor Rule that former Fed Chair Janet Yellen favored. This implies that fiscal policy alone has raised the neutral rate by over two percentage points. The discussion above suggests that cyclical factors may have pushed up the neutral rate considerably, even if long-term structural factors are still dragging it down. Since the Fed is supposed to set interest rates with an eye on what is appropriate for the economy over the next year or two, rates may end up staying too low for too long. This will cause the economy to overheat, eventually leading to a surge in inflation. The Inflation Boogeyman The good news is that none of our favorite indicators point to a major imminent inflationary upswing (Chart 22): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s proprietary Pipeline Inflation Indicator has fallen to a two-and-a-half-year low. Wage growth has accelerated, but productivity growth has increased by even more. As a result, unit labor cost inflation has been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 23). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 22No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... Chart 23... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being At that point, risks are high that inflation will move up. This could force the Fed to start raising rates aggressively in early-2021, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in mid-to-late 2021.   Stay Bullish Global Equities For Now, Turn Defensive Late Next Year Chart 24Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted The two-stage Fed tightening cycle discussed above – gradual rate hikes starting in December and continuing into 2020, and more aggressive hikes thereafter in response to rising inflation – shapes our investment views over the next few years. The Key Financial Market Forecasts Chart at the beginning of this publication provides a rough sketch of where we think the main asset classes are heading. We suspect that equities and other risk assets will be able to digest the first stage of rate tightening, albeit with heightened volatility around the time when the Fed starts preparing the market for another hike later this year. Unlike last September, earnings estimates are much more conservative. Bottom-up estimates foresee EPS rising by 3.9% in the U.S. and 5.4% in the rest of the world in 2019 (Chart 24). The combination of faster growth, easier financial conditions, and ongoing share buybacks implies some upside to these numbers. Perhaps more importantly, unlike in September, the Fed will only start hiking rates if the economy is performing well. Powell erred in saying that “rates were a long way from neutral” just when the U.S. economy was starting to slow. Had he uttered those words when U.S. growth was still accelerating, investors would have probably disregarded them. Jay Powell won’t make the same mistake again. Rather, he will make a different one: He will let the economy overheat to the point where the Fed finds itself clearly behind the curve and forced to scramble to catch up. The resulting stagflationary environment – where growth is slowing due to a shortage of available workers and inflation is on the upswing – will be toxic for equities and other risk assets. While it is difficult to be precise about timing, we recommend that investors maintain a modestly pro-risk stance over the next 12-to-18 months. However, they should pare back exposure to equities and spread product late next year before the Fed ramps up the pace of rate hikes. Prepare To Temporarily Upgrade International Stocks The U.S. stock market tends to be “low beta” compared to other bourses. If global growth accelerates in the second half of this year, international stocks will outperform their U.S. counterparts. We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and now recommend being outright long EM equities. We will be looking to upgrade both EM and European equities to overweight in the coming weeks in currency-unhedged terms once we see more confirmatory evidence of a global growth revival. We have mixed feeling about Japanese stocks. Stronger global growth will benefit Japanese multinationals, but firms focused on the domestic market may suffer if the government goes ahead and raises the sales tax in October. We would hold off upgrading Japanese stocks for the time being. At the global sector level, we pared back our defensive tilt earlier this year, after having turned more cautious last summer. We recommend that investors overweight energy and industrials. We are also warming up to financials and materials. The former will benefit from a steepening in yield curves later this year as well as from faster credit growth. The latter will gain from a more robust Chinese economy. We would maintain a neutral allocation to health care, info tech, and communication services. Real estate and utilities will both suffer once bond yields start moving higher. Classically defensive sectors such as consumer staples will also underperform.  Global Bond Yields Likely To Rise Global bond yields are likely to rise over the next 12-to-18 months as growth surprises on the upside. Yields will continue rising into the first half of 2021 as inflation accelerates. Unlike in past risk-off episodes, Treasurys will not provide much of a safe haven in the lead up to the next recession. As noted above, one of the reasons that bond yields are so low today is because the term premium is very depressed. The cumulative effect of Fed bond purchases has probably depressed the term premium, but the bigger impact has stemmed from the fact that investors see Treasurys as an insurance policy against various macro risks. Investors are accustomed to thinking that when an economy slides into recession, equity prices will fall, the housing market will deteriorate, wage gains will recede, job prospects will worsen, but at least the value of their bond portfolio will go up! The problem with this reasoning is that it is only valid when the Fed is hiking rates in response to stronger growth. If the Fed is hiking rates because inflation is getting out of hand, Treasury yields could end up rising while stocks are falling. This was actually the norm between the late-1960s and early-2000s (Chart 25). Chart 25Treasury Yields Could Rise While Stocks Fall Treasury Yields Could Rise While Stocks Fall Treasury Yields Could Rise While Stocks Fall If Treasurys lose their safe-haven status, the term premium will move higher. A vicious circle could develop where rising bond yields weaken the stock market, causing investors to flood out of both stocks and bonds and into cash, leading to even higher bond yields and lower equity prices. Investors should maintain a modest short duration stance towards Treasurys over the next 12 months, and then move to maximum underweight duration in mid-2020 as inflation starts to break out. Going long duration will only make sense once the Fed has raised interest rates into restrictive territory and the economy slides into recession. That is not likely to occur until the second half of 2021. Regionally, we favor European, Canadian, Australian, New Zealand, and especially Japanese government bonds over the next 12 months relative to U.S. Treasurys. The U.S. economy is at the greatest risk of overheating. In currency-hedged terms, the 10-year U.S. Treasury yield is among the lowest in the world (Table 1). Japanese 10-year bonds, for example, offer 2.72% in currency-hedged terms, while German bunds command 2.94%. Table 1Bond Markets Across The Developed World Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone   The U.S. Dollar: Heading Towards A Soft Patch Gauging the outlook for the U.S. dollar is a bit tricky. Even though the Fed will only be raising rates gradually over the next 12 months, it will still hike more than what is discounted by markets. With most other central banks still sitting on the sidelines, short-term rate differentials are likely to move in favor of the greenback. That said, aside from Japan, stronger global growth will likely prompt investors to price in a few more rate hikes in other developed economies in 2020 and beyond. Consequently, long-term yield differentials may not widen by as much as short-term differentials. Perhaps more importantly, the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 26). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world (Chart 27). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 26The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 27The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth If global growth picks up in the back half of this year, the dollar will likely peak in the second quarter and weaken over the remainder of 2019 and into 2020. The dollar’s trajectory may thus follow a similar course to the one in 2017, a year in which the Fed raised rates four times, but the broad trade-weighted dollar nevertheless managed to weaken by 7%. Chart 28The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency As was the case in 2017, the euro will probably gain ground later this year against the U.S. dollar as will most EM and commodity currencies. However, just as the Japanese yen failed to participate in the rally that most currencies experienced against the dollar in 2017, it will struggle to gain much traction against the greenback. The yen is a “risk-off” currency and thus tends to fall whenever global risk assets rally (Chart 28). In addition, the yen will suffer if global bond yields move up relative to JGB yields later this year, as will likely be the case if the BoJ is forced to prolong its yield curve control regime in the face of tighter fiscal policy. We would go long EUR/JPY on any break below 123. After First Weakening, The Dollar Will Rally Again Late Next Year As the U.S. economy encounters ever more supply-side constraints in 2020, growth will slow and inflation will accelerate. The Fed will respond by hiking rates more quickly than inflation is rising. The resulting increase in real interest rates will put upward pressure on the dollar. In this stagflationary environment, equities will tumble and credit spreads will widen. Tighter U.S. financial conditions will reverberate around the world, causing global growth to decelerate even more than it would have otherwise. This will further turbocharge the dollar. The greenback will only peak once the Fed starts cutting rates in late-2021. Commodities: Getting More Bullish A weaker dollar later this year, along with stronger global growth led by a resurgent China, will be bullish for commodities. BCA’s commodity strategists recommend going long copper at current prices. They are also maintaining their bullish bias towards oil. They expect Brent to average $75/bbl this year and $80/bbl in 2020. Higher U.S. shale output will be offset by delays in building out deepwater export facilities, which will keep supply fairly tight. In past reports, we discussed the merits of buying gold as an inflation hedge. However, we held back from doing so because of our bullish dollar view. Now that we see the dollar peaking over the next few months, we would be buyers of gold on any break below $1275/ounce.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 29 Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. Feature The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories promised would not mean losing access to the Common Market. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart 1). Chart 1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart 2), the erosion of its manufacturing economy (Chart 3), and the ballooning of the country’s financial sector (Chart 4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart 5). Chart 2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart 3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart 4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart 5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart 6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart 7). Chart 6 Chart 7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. The underlying economic angst has continued to influence British politics since Brexit. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart 8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart 9).3 Chart 8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart 9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. The idiosyncratic events that provided tailwinds behind Brexit … were the migrant crisis and terrorist attacks in Europe. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart 10). Neither forecast was popular with our client base, but both have been spot on. Chart 10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart 11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart 11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart 12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart 13). Chart 12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart 13...And Brits Feel More European ...And Brits Feel More European ...And Brits Feel More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. The British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart 14). Chart 14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram 1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Diagram 1Confused? You Are Not Alone The State Of Brexit The State Of Brexit Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart 15). Chart 15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. An election would induce volatility to the market as it would put Jeremy Corbyn close to the premiership. Furthermore, polling data (presented in Chart 12 and Chart 13) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart 12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart 16). Chart 16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The Conservative Party has wasted its window of opportunity to push a hard, or moderately hard, Brexit through Parliament. The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart 17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart 17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart 18). Chart 18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. It makes sense for long-term investors to buy the GBP … short-term investors should buy the 2-year call while selling 3-month ones. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart 19). Chart 19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President The Bank Credit Analyst mathieu@bcaresearch.com Footnotes 1 At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2 Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3 Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. ­4 One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5 Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7 President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line.

Highlights For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks. Tactically overweight Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM… …but prepare to take profits in the summer months. In the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps… …and EUR/USD has the scope to head higher. Feature Without a shadow of a doubt, the chart that causes the greatest stir among our clients is the Chart of the Week. It shows that one of the biggest investment decisions, the choice between the euro area and U.S. equity markets, reduces to the choice between the three large euro area banks – Santander, BNP Paribas, and ING – and the three U.S. tech behemoths – Apple, Microsoft, and Google.  Chart of the WeekEurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Clients are simultaneously amazed and unsettled by this manifestation of the Pareto Principle, which states that the vast majority of an effect is explained by a tiny minority of causes. Financials feature large in the Eurostoxx50 while tech giants dominate the S&P500. But the amazing thing is that almost all of the relative performance can be explained by just three stocks in each market. The vast majority of an effect is explained by a tiny minority of causes.  The chart creates a cognitive dissonance. What about the things that are supposed to matter for stock market selection: relative economic growth, profits growth, margins, valuations and geopolitics? The answer is that all of these are interesting areas of study, but they are mere details in the big picture. For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks (Chart I-2). Period.  Chart 2For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech Our view is that in the immediate future this is certainly possible, but that over the long haul it will prove to be a very tall order. When The Mean Is Meaningless The structural performances of vastly different equity sectors can diverge for a very long time. How long? Japanese banks have underperformed U.S. tech for thirty years and counting! In this situation, mean-reversion and ‘standard deviations’ from the mean become meaningless concepts (Chart I-3). Chart I-3Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! The statistical concept of a standard deviation is only meaningful if the underlying data is stationary, which is to say mean-reverting. If it isn’t, then it is impossible to say that a sector price or valuation is stretched either versus another sector, or versus its own history.  One problem is that sector performances and valuations undergo phase-shifts when they enter a different economic climate. The structural outlook for bank profits experiences a phase-shift when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is as meaningless as comparing your height as an adult to your height when you were a child! Sector performances and valuations undergo phase-shifts when they enter a different economic climate. To which, a frequent riposte is: within the same sector, euro area companies appear cheaper than their counterparts elsewhere in the world. But again, this apparent value is deceptive because it is simply an adjustment for the so-called ‘currency translation effect’ and the anticipated long-term moves in exchange rates. If investors anticipate the euro ultimately to strengthen – because they see that it is trading well below purchasing power parity – then a multinational company listed on a euro area bourse will suffer a future headwind to its mixed-currency denominated profits when they are translated back to a stronger euro. To discount this anticipated headwind, the euro area multinational must trade cheaper compared with a peer in, say, the U.S. But the cheapness is a false impression. Pulling together these complexities of sector effects, phase-shifts in sector valuations and currency effects, making the big call between Europe and America on the basis of performance or valuation mean-reversion is dangerous. Instead, we come back to the basic question: should you tilt towards euro area financials or towards U.S. tech? Own Banks For The Short Term Only Japanese financial sector profits peaked in 1990 and stand at less than half that level today. Euro area financial sector profits peaked in 2007, and are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan’s footsteps, expect no sustained growth through the next 17 years (Chart I-4). Chart I-4Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage – the amount of equity held against the balance sheet. More stringent European regulation is making this a headwind too. Banks have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin – the difference between rates received on loans and rates paid on deposits. In this regard, both fintech and the blockchain are likely to create a further headwind to bank profitability. Japan’s experience suggests that euro area financials will struggle to outperform structurally. Admittedly, U.S. tech may also face its own headwinds or phase-shift, most obviously antitrust lawsuits to counter its near-monopoly status. But even allowing for this, Japan’s experience suggests that euro area financials will struggle to outperform structurally. Rather, financials is a sector to play for outperformance phases lasting no more than a few quarters. Last autumn, we noted that short-term credit impulses in the major economies were flipping from a sharp down-oscillation into an up-oscillation phase (Chart I-5). On that basis, we recommended a tactical overweight to Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM. Those pro-cyclical sector positions have broadly succeeded, but they are still appropriate given that up-oscillation phases very reliably last around nine months. Chart I-5Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations The caveat is: prepare to take profits in the summer months. The Fed Is Now At ‘Neutral’, But Where Is The ECB? Last week, the Federal Reserve confirmed that “the Federal funds rate (at 2.5 percent) is now in the broad range of estimates of neutral – the rate that tends neither to stimulate nor to restrain the economy.”  This begs the question: where is the ECB policy rate (now at 0 percent) relative to its neutral? Our very high conviction view is that the ECB policy rate is well below neutral. Financials is a sector to play for outperformance phases lasting no more than a few quarters. The twenty year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Through these twenty years, the euro area versus U.S. long bond yield spread has averaged -50 bps1 (Chart I-6). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -50 bps (Chart I-7). Ergo, the real interest rate differential has averaged zero. Meaning, the ex-post neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-6The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... Chart I-7...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps With little difference in the neutral real rates over the past two decades, is there a valid reason to expect a difference in the future? An obvious response is the fragility of the euro area’s banking system will require the ECB to persist with its zero interest rate policy for years. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy. In fact, the evidence suggests that this fear is exaggerated. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy (Chart I-8). The problem has been localised in Italy, where bank lending relapsed once again in 2018. Chart I-8Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France However, on closer examination this was a direct result of political tensions. Recently, Italian bank lending has been a very tight (inverse) function of the Italian bond yield. The BTP yield spiked last year when Rome escalated its budget spat with Brussels, and bank lending took a hard hit. But now that the Italian bond yield has retraced, lending should recover (Chart I-9). Chart I-9Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down The central issue is can the U.S. policy rate – which is at neutral – and the ECB policy – which is below neutral – diverge much from here? Our high conviction answer is no. Therefore, in the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps, one way or the other (Chart I-10). Chart I-10Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? It also implies that after remaining range-bound in the immediate future, EUR/USD has the scope to head higher. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System This week’s recommended trade is to go long SEK/NOK, as it is close to the limit of tight liquidity that has signaled many previous technical reversals in this currency cross. Set a profit target of 1.5 percent with a symmetrical stop-loss. In other trades, the on-going rally in government bonds caused the short position in 30-year T-bonds to hit its stop-loss. This leaves us with five open positions. Long SEK/NOK. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long SEK/NOK Long SEK/NOK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart II-1). Chart II-1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart II-2), the erosion of its manufacturing economy (Chart II-3), and the ballooning of the country’s financial sector (Chart II-4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart II-5). Chart II-2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart II-3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart II-4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart II-5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart II-6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart II-7). Chart II-6 Chart II-7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart II-8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart II-9).3 Chart II-8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart II-9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart II-10). Neither forecast was popular with our client base, but both have been spot on. Chart II-10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart II-11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart II-11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart II-12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart II-13). Chart II-12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart II-13...And Brits Feeling More European ...And Brits Feeling More European ...And Brits Feeling More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart II-14). Chart II-14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram II-1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Chart II- Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart II-15). Chart II-15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. Furthermore, polling data (presented in Chart II-12 and Chart II-13 on page 28) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart II-12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart II-16). Chart II-16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart II-17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart II-17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart II-18). Chart II-18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart II-19). Chart II-19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic Senior Vice President Chief Geopolitical Strategist Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2       Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3       Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. 4       One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5       Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6       Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7       President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line.