Fixed Income

Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion A Brief Inversion A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Low Yields Support Risk Assets I Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Low Yields Support Risk Assets II Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Global Growth Indicators Global Growth Indicators Chart 5Catalysts For Economic Recovery Catalysts For Economic Recovery Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta Global Yield Beta Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Disappointing economic data outside the U.S. and the inversion of the 2-year/10-year portion of the Treasury curve have overshadowed positive developments on the trade front. Global growth should improve later this year, spurred on by lower bond yields and fiscal stimulus in some countries. In contrast to the consensus view, we see flatter yield curves around the world as a “glass half full” story, mainly reflecting the shift to an ultra-dovish stance by most central banks. A variety of structural forces have dragged down term premia in fixed-income markets, thus making the purported recessionary signal from an inverted yield curve less prescient. Had the U.S. term premium in the mid-1990s been anywhere close to today’s levels, the yield curve would have surely inverted, causing yield curve-obsessed investors to miss out on the biggest equity bull market in history. The meltdown in bond yields is ending. Investors should favor stocks over bonds over the next 12-to-18 months. Feature Recession Risk Forces Trump’s Hand Risk assets remain caught in the crossfire of slowing global growth, flattening yield curves, and trade war uncertainty. Stocks received a short-lived boost on Tuesday from the Trump Administration’s decision to delay raising tariffs until December 15th on roughly 60% of the Chinese imports – including smartphones, laptops, and toys – which were slated to be taxed starting September 1st. The decision followed a phone call between U.S. and Chinese trade representatives that Trump described as “very productive.” Seemingly in contradiction to his earlier claim that China will end up bearing the full cost of the tariffs, President Trump admitted that “We're doing this for the Christmas season, just in case some of the tariffs would have an impact on U.S. customers.” The fact that the trade war is weighing on growth and the stock market has not been lost on Trump. The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that 34% of managers believed that a recession is likely within the next 12 months. This is the largest share in eight years. The trade war topped the list of “biggest tail risks” for the fifth month in a row. A net 22% of investors said they had taken out protection against a sharp drop in the stock market, the highest number since the survey began asking this question in 2008. The question is whether Trump’s half-hearted attempt to hold out an olive branch to the Chinese is too little, too late. The fact that the Chinese government indicated on Thursday that it will still go ahead and take “necessary countermeasures” suggests that Trump’s overture does not go far enough. More worryingly, the meltdown in bond yields and the stock market’s failure to hold Tuesday’s gains imply that many investors think that the trade war has already pushed the global economy past the breaking point. Industrial Activity Struggling To Find A Bottom It is not helping matters that industrial activity outside the U.S. remains in a slump. It was confirmed this week that the German economy contracted in the second quarter on the back of flagging export demand. The decline in the expectations component of the German ZEW survey in August to the lowest level since 2012 suggests that growth has remained weak in the third quarter. Chinese economic activity also disappointed in July. Industrial production growth slowed significantly. Retail sales decelerated, led by a relapse in automobile sales. A variety of political developments around the world have further undermined market confidence. The protests in Hong Kong have become increasingly violent, causing severe disruptions to air travel in the region. The risks of a hard Brexit are rising. Italy’s coalition government has collapsed. And in one of the biggest daily moves on record, the Argentine stock market fell by 48% in dollar terms on Monday after its current reform-minded president, Mauricio Macri, was trounced by his left-wing rival in primary elections. Will The U.S. Be Dragged Down? The U.S. economy has held up relatively well compared with the rest of the world. Retail sales rose by 0.7% in July, the fastest pace in four months, and more than twice what analysts were expecting. While industrial production was somewhat softer than expected, both the Philly and New York Fed manufacturing surveys surprised on the upside. The forward-looking new orders component increased in both surveys. With this week’s data in hand, the Atlanta Fed’s GDPNow model is forecasting that U.S. real GDP will rise by 2.2% in Q3. Real final domestic demand, which excludes the contribution from net exports and inventories, is set to grow by an even-healthier 3% (Chart 1). Chart 1 Given the still reasonably firm U.S. data, why are so many pundits and market participants fretting about a recession? One key reason is that the yield curve has inverted. An inverted yield curve has historically been a reliable predictor of recessions (Chart 2). Chart 2The U.S. Yield Curve: Still Prescient? The U.S. Yield Curve: Still Prescient? The U.S. Yield Curve: Still Prescient? Yield Curve Angst President Trump wasted little time on Wednesday sarcastically thanking “clueless” Jay Powell and the Federal Reserve for the “CRAZY INVERTED YIELD CURVE” (emphasis his). Trump and the investment community should relax a bit. In contrast to the consensus view, we see flatter yield curves around the world as a “glass half full” story, mainly reflecting the shift to an ultra-dovish stance by most central banks. Not only has the Fed turned more dovish, but other central banks have cranked up monetary stimulus. A Wall Street Journal story published earlier today quoted Olli Rehn, the current governor of the Finnish central bank and member of the ECB’s rate-setting committee, as saying that the ECB is looking to unveil a “significant and impactful policy package” in September, adding that “When you’re working with financial markets, it’s often better to overshoot than undershoot.”1 Since short-term rates in the euro area and in a number of other countries cannot fall much from current levels, the only way for the ECB to ease financial conditions is to signal that short-term rates will stay lower for longer and to buy up long-term bonds through large-scale asset purchase programs. This naturally leads to lower bond yields and flatter yield curves. Falling bond yields in Europe and around the world have, in turn, dragged down U.S. yields. Unlike in the past, term premia are negative across the major economies. This means that investors today can expect to earn more by rolling over a short-term government security than by buying a long-term government bond. In addition to central bank asset purchases, rising demand for bonds from institutional investors has depressed term premia. Desperate to match their long-duration liabilities with equally long-duration assets, insurance companies and pension funds have been forced to purchase bonds with low (and sometimes even negative) yields. Term premia have also come down as investors have grown accustomed to seeing bonds as a good hedge against equity risk in particular, and recession risk in general (Chart 3). Chart 3Owning Long-Term Bonds Is A Good Hedge Against Equity Risk Owning Long-Term Bonds Is A Good Hedge Against Equity Risk Owning Long-Term Bonds Is A Good Hedge Against Equity Risk As such, one should take the purported recessionary signal from an inverted yield curve with a grain of salt. Today, the U.S. 10-year term premium stands at -1.2%. In late 1994, when the yield curve almost inverted, the term premium was 1.9%. Had the U.S. term premium in the mid-1990s been anywhere close to present levels, the yield curve would have surely inverted, causing yield curve-obsessed investors to miss out on the biggest equity bull market in history. TINA’s Siren Song For investors, the collapse in bond yields increasingly means that There Is No Alternative to equities. We will have much more to say about “TINA” in a forthcoming special report; but for now, suffice it to say that ultra-low bond yields have improved the relative attractiveness of stocks. The S&P 500 dividend yield is currently 2.03%, 51 bps above the yield on 10-year Treasury notes (Chart 4). To put things in perspective, even if S&P 500 companies did not increase cash dividends at all for the next ten years, the real value of the index would still have to fall by 28% (assuming 2% inflation) for bonds to outperform stocks. Chart 4S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield All this means that global growth is probably close to a bottom. This, in turn, implies that the meltdown in bond yields is likely to end soon. Investors should favor stocks over bonds over the next 12-to-18 months. Chart 5 shows that the equity risk premium in the U.S. remains well above its historic norm. The equity risk premium is even higher outside the U.S., reflecting both the fact that valuations are cheaper abroad and that interest rates are generally lower. Chart 5AEquity Risk Premia Remain Well Above Their Historic Norms (I) Equity Risk Premia Remain Well Above Their Historic Norms(I) Equity Risk Premia Remain Well Above Their Historic Norms(I) Chart 5BEquity Risk Premia Remain Well Above Their Historic Norms (II) Equity Risk Premia Remain Well Above Their Historic Norms(II) Equity Risk Premia Remain Well Above Their Historic Norms(II) It is useful to contrast today’s high equity risk premia with the fact that global cash allocations in the latest BofA Merrill Lynch survey stood at 5.1% in August (1.5 standard deviations above their long-term average). Bond allocations were also 1.1 standard deviations above their long-term average. On the flipside, asset allocators were net 12% underweight stocks (1.7 standard deviations below their long-term average). In fact, aside from June of this year, this represents the biggest equity underweight since March 2009. Given this backdrop, stocks are likely to continue to climb the proverbial wall of worry. Investment Conclusions We argued in our August 2nd report that risk assets are likely to face some near-term pressure.2  That pressure has been realized. At this point, we would not be chasing stocks lower. Yes, global growth, at least outside the U.S., remains weak. Encouragingly, however, the slowdown has been largely confined to the manufacturing sector. Unlike in 2008, the service sector has remained fairly resilient (Chart  6). Even in Germany, the service PMI has actually risen since late last year. Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) Global manufacturing cycles tend to last three years – 18 months up, 18 months down (Chart 7). The last downleg began in early 2018. Provided the trade war does not spiral out of control, we are due for another upturn in manufacturing activity. Chart 7The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Chart 8Looser Fiscal Policy In The Euro Area Looser Fiscal Policy In The Euro Area Looser Fiscal Policy In The Euro Area   A bit more fiscal stimulus should help. Chinese credit growth came in much weaker-than-expected in July. With growth still soggy there, we expect the Chinese authorities to redouble stimulus efforts over the coming months. Fiscal policy in the euro area is also being loosened (Chart 8). Further easing is likely in Germany, where support for a German version of a “Green New Deal” is gaining traction.  All this means that global growth is probably close to a bottom. This, in turn, implies that the meltdown in bond yields is likely to end soon. Investors should favor stocks over bonds over the next 12-to-18 months. We expect to upgrade EM and European equities during the next few months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     1      Tom Fairless, “ECB Has Big Bazooka Primed for September, Top Official Says,” The Wall Street Journal, August 15, 2019. 2      Please see Global Investment Strategy Weekly Report, “A One-Two Punch,” dated August 2, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 9 Tactical Trades Strategic Recommendations Closed Trades

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting EM EPS Are Contracting EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling China: Building Construction Is Dwindling China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China... Breakdowns In Korea And China... Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well bca.ems_wr_2019_08_15_s1_c12 bca.ems_wr_2019_08_15_s1_c12 Chart I-13German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Which Way These Gaps Will Close? Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy EM Credit Markets Is Toppy EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Steel Production In China Steel Production In China Chart II-3No Recovery In Chinese Demand No Recovery In Chinese Demand No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations