Geopolitics

Following drone attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) over the weekend, which removed ~ 5.7mm b/d of output, the U.S. is likely to conduct a limited retaliatory strike. In addition, the U.S. will continue to build up forces in the Persian Gulf to deter Iran and prepare for a larger response if necessary. After this initial response, the Trump administration will likely seek to contain tensions, as neither Trump nor the United States has an immediate interest in launching a large-scale conflict with Iran. But that does not mean that one will not happen – indeed, the odds are now higher that this risk could materialize. If the oil-price shock caused by these attacks becomes prolonged and unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the negative impact on the global and U.S. economy will grow. Faced with a recession – which is not our base case but is possible – the incentive for Trump to engage war with Iran will rise sharply. Attack On KSA Will Prompt U.S. Retaliation If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions. Over the weekend, Houthi rebels in Yemen claimed responsibility for attacks on two critical oil assets in Saudi Arabia, removing ~ 5.5% of world crude output – a historic shock to global oil supply, and the largest unplanned outage ever recorded (Chart 1).1 U.S. Secretary of State Mike Pompeo accused Iran of being behind the attacks and said there was no evidence that Houthis launched them from Yemen. As we go to press, neither Saudi Arabian officials nor President Trump have confirmed Iran was the culprit, although the sophistication of the attack’s targeting and execution suggest that they will. President Trump said the U.S. is “locked and loaded depending on verification” and offered U.S. support to KSA in a call to Crown Prince Mohammad Bin Salman.2 Chart 1Oil Supply Disruption + Volume Lost Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response A direct missile strike from Iran is the least likely source, as the Iranians have sought to act through proxies this year, in staging attacks to counter U.S. sanctions, precisely in order to maintain plausible deniability and avoid provoking a full-blown American retaliation. If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions, relative to a situation where militant groups in Iraq or Yemen (or even in Saudi Arabia) are found to be responsible. Assuming the strike came from outside Iran, the U.S. and Saudi Arabia would presumably retaliate against its proxies in those locations – e.g., the Houthis in Yemen, or the Shia militias in Iraq. Washington is certain to dial up its military deterrent in the region and use the attacks to gain greater worldwide support for a tighter enforcement of sanctions to isolate Iran. This deterrence includes a multinational naval fleet in the Strait of Hormuz, at the entrance to the Gulf, where ~ 20% of the world’s crude oil supply transits daily. Electoral Constraints Facing Trump There are several reasons President Trump will not rush to a full-scale conflict with Iran. First, the attack did not kill U.S. troops or civilians. Miraculously, not even a single casualty is reported in Saudi Arabia. Yet, unlike the Iranian shooting of an American drone, which nearly brought Trump to launch air strikes on June 21, the latest attack clearly impacted critical infrastructure in a way that threatens global stability, making it more likely that some retaliation will occur. Second, Trump faces a significant electoral constraint from high oil prices. True, the U.S. economy is not as exposed to oil imports as it was (Chart 2). Also, global oil producers and strategic reserves including the U.S. Strategic Petroleum Reserve (SPR) can handle the immediate short-term loss from KSA (Chart 3). However, the duration of the cut-off is unknown and further disruptions will occur if the U.S. retaliates and Iranian-backed forces attack yet again. Third, there is still a chance to show restraint in retaliation, contain tensions over the coming months, limit oil supply loss and price spikes, and thus keep an oil-price shock from tanking the U.S. economy. Chart 2U.S. Imports Continue Falling U.S. Imports Continue Falling U.S. Imports Continue Falling But as tensions escalate in the short term, they could hit a point of no return at which the economic damage becomes so severe that President Trump can no longer seek re-election based on his economic record (Chart 4). At that point the incentive is to confront Iran directly – and run in 2020 as a “war president” intent on achieving long-term national security interests despite short-term economic pain. Chart 3Key SPRs Are Still Adequate Key SPRs Are Still Adequate Key SPRs Are Still Adequate Chart 4An Oil Price Shock Lowers Trump's Re-Election Chances An Oil Price Shock Lowers Trump's Re-Election Chances An Oil Price Shock Lowers Trump's Re-Election Chances U.S.’s Volatile Attempt At Diplomacy What triggered the attack and what does it say about the U.S. and Iranian positions going forward? Ever since Trump backed away from air strikes in June, he has become more inclined to de-escalate the conflict he began with Iran by withdrawing from the 2015 Joint Comprehensive Plan of Action (JCPOA), designating the Islamic Revolutionary Guard Corps (IRGC) as terrorists, and imposing crippling sanctions to bring Iran’s oil exports to zero. Even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions. What prompted this backtracking was Iran’s demonstration of a higher pain threshold than Trump expected. President Hassan Rouhani, and his Foreign Minister Javad Zarif, were personally invested in the 2015 nuclear deal with the Obama administration, which they negotiated despite grave warnings from the regime’s conservative factions that they would be betrayed. Trump’s reneging on that deal confirmed their opponents’ expectations, while his sanctions have sent the economy into a crushing recession (Chart 5). Chart 5U.S. Sanctions Hammer Iran's Economy U.S. Sanctions Hammer Iran's Economy U.S. Sanctions Hammer Iran's Economy With Iranian parliamentary elections in February 2020, and a consequential presidential election in 2021 in which Rouhani will seek to support a political ally, the Rouhani administration needed to respond forcefully to Trump’s sanctions. Iran staged several provocations in the Strait of Hormuz to warn the U.S. against stringent sanctions enforcement (Map 1). And recently, even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions, a very high bar for talks. Map 1Abqaiq Is At The Very Core Of Global Oil Supply Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Realizing the large appetite for conflict in Tehran, and the ability to sustain sanctions and use proxy warfare damaging global oil supply, Trump took a step back – he withheld air strikes in late June, discussed a diplomatic path forward with French President Emmanuel Macron, and subsequently fired his National Security Adviser John Bolton, a known war hawk on Iran who helped mastermind the return to sanctions. The proximate cause of Bolton’s ouster was reportedly a disagreement about sanctions relief that would have been designed to enable a meeting with Rouhani at the United Nations General Assembly next week. Such a summit could possibly have led to a return to the pre-2017 U.S.-Iran détente. If Trump had compromised, Iran could have gone back to observing the 2015 nuclear pact provisions, which it has only gradually and carefully violated. Moreover the French proposal to convince Iran to rejoin talks by offering a $15 billion credit line for sanctions relief was gaining traction. Apparently these recent moves toward diplomacy posed a threat to various actors in the region that benefit from U.S.-Iran conflict and sanctions. Hardliners in Iran want to weaken the Rouhani administration and prevent further Rouhani-led negotiations (i.e. “surrender”) to American pressure. On August 29, three days after Rouhani hinted that he might still be willing to talk with Trump, Supreme Leader Ayatollah Ali Khamenei’s weekly publication warned that “negotiations with the U.S. are definitely out of the question.”3 The IRGC and others continue to benefit from black market activity fueled by sanctions. And Iranian overseas militant proxies have their own reasons to fear a return to U.S.-Iran détente. Saudi Arabia and Israel also worry that President Trump will follow in President Obama’s footsteps with Iran and strategic withdrawal from the Middle East, which has considerable popular support in the United States (Chart 6). Both the Saudis and Israelis have been emboldened by the Trump administration’s support and have expanded their regional military targeting of Iranian-backed forces, prompting Iranian pushback. The hard-line factions know that a full-fledged American attack would be devastating to Iranian missile, radar, and energy facilities and armed forces. The Iranians remember the devastating impact on their navy from Operation Praying Mantis in 1988. But with the Trump administration’s “maximum pressure” sanctions cutting oil exports nearly to zero, Iran’s economy is getting strangled and militant forces may feel they have no choice. Chart 6Americans Do Not Support War With Iran Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Moreover Trump’s electoral constraint – his need to make deals in order to achieve foreign policy victories and lift his weak approval ratings ahead of the election – means that foreign enemies have the ability to drive up the price of a deal. This is what the Iranians just did. But negotiations may be impossible now before 2020. Rouhani may be forced to play the hawk, Supreme Leader Khamenei is opposed to talks, and the hard-line faction is apparently willing to court conflict with America to consolidate its power ahead of the dangerous and uncertain period that awaits the regime in the near future, when Khamenei’s inevitable succession occurs. Bottom Line: We argued in May that the risk of U.S. war with Iran stood as high as 22%, on a conservative estimate of the conditional probability that the U.S. would engage in strikes if Iran restarted its nuclear program outside of the provisions of the JCPOA. Recent events make the risk even higher. This does not mean that Rouhani and Trump cannot make bold diplomatic moves to contain tensions, but that the risk of widening conflict is immediate. Supply Risk Will Remain Front And Center The risk to supply made manifest in these drone attacks will remain with markets for the foreseeable future. They highlight the vulnerability of supply in the Gulf region, and, importantly, the now-limited availability of spare capacity to offset unplanned production outages. There’s ~ 3.2mm b/d of spare capacity available to the market, by the International Energy Agency’s reckoning, some 2mm b/d or so of which is in KSA (Chart 7). These drone attacks highlight the need to risk-adjust this spare capacity. When the infrastructure needed to deliver it to markets comes under attack, its availability must be adjusted downward. Chart 7Limited Availability Of Spare Capacity To Offset Outages Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Chart 8Commercial Inventories Will Draw ... Commercial Inventories Will Draw ... Commercial Inventories Will Draw ... In the immediate aftermath of the temporary loss of ~ 5.7mm b/d of KSA crude production to the drone attacks, we expect commercial inventories to be drawn down hard, particularly in the U.S., where refiners likely will look to increase product exports to meet export demand (Chart 8). This will backwardate forward crude oil and product curves – i.e., promptly delivered oil will trade at a higher price than oil delivered in the future (Chart 9). Chart 9... Deepening Forward-Curve Backwardations ... Deepening Forward-Curve Backwardations ... Deepening Forward-Curve Backwardations We expect the U.S. SPR to monitor this evolution closely. It is near impossible to handicap the level of commercial inventories – or backwardation – that will trigger the U.S. SPR release, given the unknown length of the KSA output loss, however. Worth noting is the fact that U.S. crude-export capacity is limited to ~ 1mm b/d of additional capacity. Thus, the SPR cannot be directly exported to cover the entire loss of KSA barrels. Other members of OPEC 2.0 will be hard-pressed to lift light-sweet exports, which, combined with constraints on U.S. export capacity, mean the light-sweet crude oil market could tighten. Interestingly, these attacks come as the U.S. has been selling down its SPR. The sales to date have been to support modernization of the SPR, but, for a while now, the Trump administration has been signalling it no longer believes they are critical to U.S. security. That likely changes with these events. The EIA estimates net crude-oil imports in the U.S. are running at 3.4mm b/d. The SPR is estimated at 645mm barrels. There are 416mm barrels of commercial crude inventories in the U.S., giving ~ 1.06 billion barrels of crude oil in the SPR and commercial inventory in the U.S. This translates into about 312 days of inventory in the U.S. when measured in terms of net crude imports. China has been building its SPR, which we estimated at ~ 510mm barrels. As a rough calculation using only China imports of ~ 10mm b/d, and production of ~ 3.9mm b/d, net crude-oil imports are probably around 6mm b/d. With SPR of ~ 510mm barrels, the public SPR (i.e., state-operated stocks) equates to roughly 85 days of imports.4 Members of the IEA – for the most part OECD states – are required to have 90 days of oil consumption on hand. The IEA estimates its SPR totals 1.54 billion barrels, which consists of crude oil and refined products. Together, the IEA’s SPRs plus spare capacity likely could cover the loss of KSA’s crude exports, but the timing and coordination of these releases will be tested. KSA has ~ 190mm b/d of crude oil in storage as of June, the latest data available from the Joint Organizations Data Initiative (JODI) Oil World Database. If the 5.7mm b/d of output removed from the market by these oil attacks persists, these stocks would be exhausted in 33 days. Based on press reports, repairs to the KSA infrastructure will take weeks – perhaps months – which means the longer it takes to repair these facilities the tighter the global oil market will become. This is exacerbated if additional pipelines or infrastructure in KSA come under attack or are damaged. Critical Next Steps How the U.S. follows up Pompeo’s accusations against Iran will be critical. The next steps here are critical: Tactically, the Houthis or other Iranian proxies could continue with drone attacks aimed at KSA infrastructure. They’ve obviously figured out how to target Abqaiq, which is the lynchpin of KSA’s crude export system (desulfurization facilities there process most of the crude put on the water in the Eastern province). The Abqaiq facility has been hardened against attack, but these attacks show the supporting infrastructure remains vulnerable. In addition, militants could target KSA’s western operations on the Red Sea, which include pipelines and refineries. The Bab el-Mandeb Strait at the bottom of the Red Sea empties into the Arabia Sea. More than half the 6.2mm b/d of crude oil, condensates and refined-product shipments transiting the strait daily are destined for Europe, according to the U.S. EIA.5 In addition, the 750-mile East-West pipeline running across KSA terminates on the Red Sea at Yanbu. The Kingdom is planning to increase export capacity off the pipeline from 5mm b/d to 7mm b/d, a project that will take some two years to complete.6 During a July visit to India, former Energy Minister Khalid al-Falih stated importers of Saudi crude and products, “have to do what they have to do to protect their own energy shipments because Saudi Arabia cannot take that on its own.” On top of all this, Iran could ramp up its threats to shipping through the Strait of Hormuz once again. These actions could put the risk to supply into sharp relief in very short order. Even Iranian rhetoric will have a larger impact in this environment. In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage. How the U.S. follows up Pompeo’s accusations against Iran will be critical. Whether the deal being brokered with France – and the $15 billion oil-for-money loan from the U.S. that goes with it – is now DOA, or is put on a fast track to reduce tensions in the region will be telling. It is entirely possible the U.S. launches an attack on Yemen to take out these drone bases and to neutralize the threat there. If Iraq is identified as the source of the attacks, the U.S., along with Iraqi forces, likely would stage a special-forces operation to take out the bases used to launch the drone attacks. The U.S. has significant forces in theater right now: The U.S. 5th Fleet is in Bahrain, with the Abe Lincoln aircraft carrier and its strike force on station at the Strait of Hormuz; and the USS Boxer Amphibious Ready Group (ARG) and 11th Marine Expeditionary Unit (MEU) are on patrol in the Red Sea under the command of the U.S. 5th Fleet (Map 2). In addition, the U.S. also deployed B52s earlier this year to Qatar to have this capability in theater. Map 2U.S. Navy Carrier Battle Group Disposition, 9 September 2019 Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Bottom Line: In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage that removed 5.7mm b/d of crude-processing capacity from the market and damaged one Saudi Arabia’s largest oil fields. We expect the U.S. will conduct a limited retaliatory strike, and will continue to build up forces in the Persian Gulf to prepare for a larger response if necessary. While neither President Trump nor the United States has an immediate interest in a large-scale conflict with Iran, the risk of such an outcome has increased. If the oil-price shock caused by these attacks becomes unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the risk of recession increases. While this is not our base case, it could push Trump to adopt a “war president” strategy going into the U.S. general election next year.   Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil field, which produces close to 2mm b/d, were attacked on Saturday, September 14, 2019.  Since then, press reports claim the attack could have originated in Iraq or Iran, and could have included cruise missiles – a major escalation in operations in the region involving Iran, KSA and their respective allies – in addition to drones.  Please see Suspicions Rise That Saudi Oil Attack Came From Outside Yemen, published by The Wall Street Journal September 14, 2019. 2      Please see "Houthi Drone Strikes Disrupt Almost Half Of Saudi Oil Exports", published September 14, 2019, by National Public Radio (U.S.). 3      See Omer Carmi, "Is Iran Negotiating Its Way To Negotiations?" Policy Watch 3172, The Washington Institute, August 30, 2019, available at www.washingtoninstitute.org. 4      China is targeting ~500mm bbls by 2020, and is aiming to have 90 days of import oil cover in its SPR. 5      Please see The Bab el-Mandeb Strait is a strategic route for oil and natural gas shipments, published by the EIA August 27, 2019. 6      Please see "Saudi Arabia aims to expand pipeline to reduce oil exports via Gulf," published by reuters.com July 25, 2019.

Highlights We remain bullish on global equities and spread product but acknowledge a variety of risks to our thesis. One such risk involves a scenario where a weaker U.S. economy hurts President Trump’s re-election prospects, causing investors to price in an Elizabeth Warren victory. According to the betting markets, she is the current front-runner for the Democratic nomination. A Warren presidency would likely be bad news for drug makers and health care insurers, defense contractors, banks, oil and gas companies (especially frackers), and tech stocks. Infrastructure and home builder stocks would probably benefit at the margin. Despite these risks, equity investors can take comfort in the following: 1) Global growth should strengthen, thanks in part to easier monetary policies; 2) China will be more keen to cut a trade deal with Trump if Warren looks like she will become the Democratic nominee; and 3) A Warren victory is less likely to translate into a Democratic takeover of the Senate than, say, a Biden victory. Feature The Warren Factor We remain bullish on global equities and other risk assets but continue to be on the lookout for evidence of any scenario that could undermine our thesis. One particular risk, which we explore in this week’s report, is the possibility that a weaker U.S. economy further undermines Donald Trump’s poll numbers, thus raising the odds that Democratic Senator Elizabeth Warren wins the White House next year. Presidential approval ratings tend to correlate well with the state of the economy (Chart 1). Since 1952, no sitting president has lost an election when unemployment has been falling except for Gerald Ford in the wake of Nixon’s scandal and unprecedented resignation. In contrast, two presidents (Jimmy Carter and George H.W. Bush) have lost against the backdrop of rising unemployment. Chart 1Incumbents Fare Better When The Economy Is Doing Well Elizabeth Warren And The Markets Elizabeth Warren And The Markets President Trump’s approval ratings are quite poor given how low unemployment is these days. His perceived handling of the economy is the only area where he has continued to poll relatively well (Chart 2). If he were to lose his standing on this issue, his re-election prospects would deteriorate substantially. Chart 2Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Elizabeth Warren And The Markets Elizabeth Warren And The Markets Among the Democratic contenders, Elizabeth Warren is currently running behind Joe Biden in the polls, but bests Biden in online betting markets such as PredictIt (Chart 3). It is not clear if Warren’s standing in the betting markets is a statistical anomaly or truly reflects the “wisdom of the crowds.” Warren tends to poll best among better-educated voters – the sort who are more likely to use betting markets. Like Andrew Yang, who PredictIt gives a rather dubious 12% chance of winning the Democratic nomination (above the 11% garnered by Kamala Harris), Warren’s prospects may be inflated by the composition of the betting pool. That said, Warren is benefiting from a deep-seated shift to the left in political preferences among Democratic primary voters, as BCA’s Geopolitical Strategy recently observed in a report entitled “American Politics Warrants Near-Term Caution.1” Chart 4 shows that the share of Democrats who identify as “liberal” has more than doubled since the mid-1990s at the expense of those who identify as “moderate” or “conservative.” The “Great Awokening” is transforming the Democratic Party into a much more radical force than it was under Bill Clinton or even, for that matter, under Barack Obama.2 Chart 3Who Will Win The 2020 Democratic Nomination? Elizabeth Warren And The Markets Elizabeth Warren And The Markets Chart 4Democratic Party Shifting To The Left Elizabeth Warren And The Markets Elizabeth Warren And The Markets   Soak The Rich If Donald Trump was the right’s answer to populism, Warren, along with fellow traveler Bernie Sanders, is the left’s embodiment of the populist spirit. Not only has Warren pledged to raise the federal minimum wage to $15/hour, she has promised to roll back Trump’s corporate tax cuts. If that were not enough, she has also touted a 2% annual wealth tax on households with a net worth in excess of $50 million (rising to 3% for those with a net worth above $1 billon). Her team claims the wealth tax would bring in $2.75 trillion over a 10-year period (roughly 1% of GDP).3 It would help finance free universal health care coverage, fund a “Green New Deal,” and pay off most student loans. A Different Type Of Protectionist While Warren holds fairly protectionist views on international trade, they are qualitatively different from Trump's vision. Whereas Donald Trump has focused his efforts on reducing America’s bilateral trade deficits with other economies, Warren has concentrated on “social justice” issues. In the first few decades following World War II, trade agreements strove to cut tariffs and other overt trade barriers. Once this had been largely achieved, negotiations began to focus on fostering what trade economist Robert Lawrence has called “deep integration.” This involved harmonizing tax and regulatory policies across countries, strengthening intellectual property rules, and so on. Warren and other critics on the left have complained that this newfound emphasis of trade policy has helped multinational companies at the expense of ordinary workers. She has espoused creating prerequisites for all future trade agreements, including stronger protections for human rights, collective-bargaining, and environmental standards. Such preconditions would make it difficult for many countries, China included, to reach a deal with the U.S. on trade. What Warren Means For Investors Regardless of what one thinks about the overall merits of Elizabeth Warren’s political agenda, it is reasonable to conclude that equity investors would suffer if most of her preferred policies were implemented. In fact, as we were writing this report, Warren retweeted a CNBC story entitled “Wall Street executives are fearful of an Elizabeth Warren presidency” with a trollish comment saying “I’m Elizabeth Warren and I approve this message.”4 Box 1 reviews the impact of a Warren victory on various industries. Briefly stated, a Warren presidency would likely be bad news for drug makers and health care insurers, defense contractors, banks, oil and gas companies (especially frackers), and tech stocks. Infrastructure and home builder stocks would probably benefit at the margin. BOX 1 Elizabeth Warren’s Impact On U.S. Equity Sectors Negative Health care: Favors eliminating private health insurance; Backs price controls on pharmaceuticals; Advocates creating a government-owned pharmaceutical manufacturer to mass-produce generic drugs. Banks: Supports making it easier for individuals to file for bankruptcy; Would restore Glass-Steagall, effectively reversing some the mergers that took place during the financial crisis; Favors making private equity firms responsible for the debts of the companies they purchase as well as for some of their pension obligations. Defense: Has called for a smaller defense budget and promised to end “the stranglehold of … the so-called Big Five defense contractors.” Energy: Pledged to sign an executive order on her first day in office placing a complete moratorium on all new fossil fuel leases for offshore drilling and on public lands; Favors banning fracking everywhere and supports the introduction of a cross-border carbon tax. Tech: Anti-trust efforts are likely to be increased under a Warren administration. She has singled out Amazon, Facebook, and Google as companies she believes should be broken up. She recently added Apple to the list, citing her belief that the Apple app store unfairly gives an edge to Apple products. Marginally Positive Infrastructure: Infrastructure stocks (except for nuclear) would probably benefit from a Warren victory due to increased public-sector investment spending. Home builders: Home builders could gain from stepped-up efforts to expand home ownership. Warren is also in favor of decriminalizing illegal immigration which, despite her ostensible efforts to help blue collar workers, could dampen wage pressures in the construction sector. Despite these clear downside risks, we would dissuade investors from turning bearish on stocks right now. There are a few reasons for this. Global Growth Should Rebound Chart 5Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth First and foremost, global growth is likely to stabilize over the coming months and rebound into yearend. Global financial conditions have loosened significantly, thanks in part to easier central bank policy (with the ECB’s rate cut and QE announcement this week being just the latest example). Looser financial conditions are positive for growth prospects (Chart 5). Manufacturing activity has been held back by weakness in the auto sector (Chart 6). Judging by the outperformance of auto stocks since mid-August (Chart 7), the auto recession may be coming to an end (we have been recommending global auto stocks since August 29). Chart 6Auto Sector: The Culprit Behind The Manufacturing Slowdown Auto Sector: The Culprit Behind The Manufacturing Slowdown Auto Sector: The Culprit Behind The Manufacturing Slowdown Chart 7Global Auto Manufacturers: Better Times Ahead? Elizabeth Warren And The Markets Elizabeth Warren And The Markets     In the U.S., the economic surprise index has jumped firmly into positive territory (Chart 8). Real consumer spending is on track to rise by a sturdy 3.1% in Q3, according to the Atlanta Fed’s GDPNow model, following a blockbuster 4.7% reading in Q2. Given the decline in mortgage rates over the past few months, residential investment should also recover later this year (Chart 9).       Chart 8U.S. Data Has Begun To Surprise On The Upside U.S. Data Has Begun To Surprise On The Upside U.S. Data Has Begun To Surprise On The Upside Chart 9Lower Mortgage Rates Bode Well For Housing Lower Mortgage Rates Bode Well For Housing Lower Mortgage Rates Bode Well For Housing Trump, Warren, And Trade The trade war represents the biggest risk to our sanguine outlook on global growth. Now that Trump has proven his credentials as “Tariff Man,” he has to prove that he is the “Master Negotiator” he claimed to be on the campaign trail. This means getting a deal done with China. As we saw with the revised NAFTA agreement, the new deal does not need to be radically different from the status quo for Trump to sell it as a game changer, and a 'win' for the American people. Trump’s decision to delay the October 1st tariff hikes by two weeks, following China’s announcement that it will waive tariffs on some U.S. imports, certainly moves things in the right direction. As we go to press, conflicting media reports are circulating that Trump is considering an interim trade deal that would delay and possibly roll back some U.S. tariffs in exchange for commitments from China to purchase more U.S. agricultural goods and better enforce intellectual property rights.5 If such an agreement materializes, it would be very much consistent with our expectation of a de-escalation in the trade war as the election approaches. How Warren’s ascent could alter the trade war calculus is unclear. On the one hand, given her own protectionist leanings, Trump may be reluctant to cede any ground to her by further softening his stance towards China. On the other hand, the Chinese are more likely to cut a deal with Trump if Biden’s star continues to fade, thus making it easier for Trump to secure an agreement. From China’s perspective, better the devil you know than the devil you don’t. On balance, we lean towards the latter theory, although much will depend on how the ongoing trade negotiations unfold. Trump Prefers Warren What does seem certain is that Trump’s re-election prospects are better if Warren gets the nomination than if Biden does. In head-to-head matchups against Trump, Biden outperforms Warren in the country as a whole, as well as in individual swing states (Chart 10). Chart 10Biden's Chances Of Beating Trump Are Better Than Warren’s Elizabeth Warren And The Markets Elizabeth Warren And The Markets Even if Warren did become the nominee and went on to beat Trump, her margin of victory would be slimmer than Biden’s. This implies that she would have a smaller chance of bringing over the Senate to the Democratic side. Without Democratic control of the senate, the Republicans will thwart much of her agenda and many of the pro-business policies they have enacted will remain on the books. Investment Conclusions When it comes to investing, there is no shortage of risks to worry about. One way of benchmarking the degree to which stocks are discounting these risks is by estimating the equity risk premium. Today, equity risk premia remain fairly elevated, especially outside the United States (Chart 11). Chart 11AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 11BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II)   One can see this point by calculating how much various stock market indices would need to fall over, say, the next ten years for stocks to underperform bonds. Even if one were to assume that nominal dividend payments per share do not rise at all over the next decade, U.S. equities would still need to decline by more than 18% in real terms for stocks to underperform bonds. Japanese stocks would need to fall by 28%. Euro area stocks would need to drop by 41%. U.K. stocks would need to tumble by almost 60%! (Chart 12). Chart 12AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 12BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Stocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II)   To be sure, much of the relative attractiveness of stocks is a function of how low real yields are. In absolute terms, global equities are poised to deliver long-term real returns on par with their historic average. U.S. stocks should generate returns that are somewhat below their historic average given that they trade at premium to their global peers. Valuations are mainly useful for gauging the long-term outlook for assets. Over a horizon of around 12 months, cyclical factors are the dominant drivers of both stocks and bonds (Chart 13). The rebound in government bond yields since last Thursday has erased most of the extreme overbought conditions that prevailed in fixed-income markets. Nevertheless, as we highlighted in last week’s report entitled “Bond Yields Have Hit Bottom,” yields should move higher over the coming months as global growth picks up and inflation eventually rises.6 As a countercyclical currency, the dollar should also start to weaken later this year. The combination of stronger global growth and a weaker dollar will boost commodity prices, EM currencies and equities, and cyclical stocks. Industrials, materials, and energy stocks should all gain. Financials will also benefit from a modest resteepening of yield curves. Financials are overrepresented in value indices while tech is underrepresented. Indeed, a trade that is long the former while short the latter has tracked the value/growth split very closely (Chart 14). Value stocks are very cheap compared to growth stocks based on standard valuation measures such as price-to-earnings, price-to-book, and dividend yield. The outperformance of value stocks over the past few days versus both growth and momentum stocks is likely to continue. Chart 13Economic Growth Drives Stocks And Bonds Over 12-Month Horizons Economic Growth Drives Stocks And Bonds Over 12-Month Horizons Economic Growth Drives Stocks And Bonds Over 12-Month Horizons Chart 14Is Value Turning The Corner? Is Value Turning The Corner? Is Value Turning The Corner?   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Weekly Report, “American Politics Warrants Near-Term Caution,” dated July 19, 2019. 2      Matthew Yglesias, “The Great Awokening,” Vox, April 1, 2019. 3      Please see Emmanuel Saez and Gabriel Zucman, January 18, 2019. 4      Elizabeth Warren, “I'm Elizabeth Warren and I approve this message,” Twitter, 10 September 2019, 2:39 pm. 5      Jenny Leonard and Shawn Donnan, “Trump Advisers Considering Interim China Deal to Delay Tariffs,” Bloomberg, September 12, 2019. 6      Please see Global Investment Strategy Weekly Report, “Bond Yields Have Hit Bottom,” September 6, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Elizabeth Warren And The Markets Elizabeth Warren And The Markets Strategic Recommendations Closed Trades

Highlights Trump is now clearly retreating from policies that harm the economy and reduce his reelection chances. Geopolitical risks are abating for the first time since May – a boon for financial markets amid global policy stimulus. The U.S. and China are containing tensions in the short term – though we remain skeptical about a final trade agreement. The U.S. election cycle is a rising source of political risk even as global risks fall – but Warren is not a reason to turn cyclically bearish. Book gains on our long spot gold trade. Feature President Trump is staging a tactical retreat from his “maximum pressure” foreign and trade policies. As a late-cycle president with an election looming, his decision to escalate conflicts with China and Iran in May revealed a voracious risk appetite. This “war president” mentality – the idea that Trump would reconnect with his political base ahead of 2020 at the risk of undermining his own economy – led us to recommend a defensive position over the course of the summer, even though we remained cyclically bullish. Now with Trump’s backpedaling this tactical narrative is starting to turn. The shift adds policy support to the recent up-tick in critical risk-on indicators (Chart 1). While U.S.-China fears have played a much greater role than Brexit in the political tailwind behind global government bond yields (Chart 2), the collapse of Boris Johnson’s no-deal gambit is also helping geopolitical risk to abate. Chart 1Risk-On Indicators Flash Green Risk-On Indicators Flash Green Risk-On Indicators Flash Green Chart 2China Political Risk To Ease (Brexit Is Nice Too) China Political Risk To Ease (Brexit Is Nice Too) China Political Risk To Ease (Brexit Is Nice Too) Unfortunately, it is too soon to sound the all-clear: The U.S. election cycle still warrants caution. As we highlighted in July, the rise of the progressive wing of the Democratic Party, particularly firebrand Senator Elizabeth Warren of Massachusetts, is causing jitters in the marketplace. Warren is on the cusp of displacing Vermont Senator Bernie Sanders as the second-place candidate behind former Vice President Joe Biden. Biden remains the frontrunner – which helps to support a constructive cyclical view – but the progressives have a tailwind and his status could change. Moreover, the entire primary process and U.S. election cycle will engender policy uncertainty and “black swan” risks. Trump’s pivot could come too late to save the bull market. There are still significant risks to our House View that equities will be higher in a year’s time. If a bear market and recession become a foregone conclusion, then Trump will have to return to a war footing. This means escalating the conflict with China or confronting Iran in a desperate bid to get voters to rally around the flag. This is a substantial political risk given that the odds of a recession are elevated and rising. Despite these risks, it is significant for the global macro view that President Trump is making a last ditch effort to save the business cycle while it can still be saved. This supports BCA’s House View that investors should maintain a cyclical risk-on orientation. How Do We Know Trump Is In Retreat? Here are the critical signs that Trump is downgrading his administration’s level of aggression after another summer of “fire and fury”: The U.S. and China are now officially easing tensions. Trump has delayed the October 1 tariff hike (from 25% to 30% on $250 billion worth of goods), while China has issued waivers for tariffs and promised to increase purchases of U.S. farm goods in advance of talks. Talks are resuming with the principal negotiators set to meet face-to-face after China’s National Day celebration on October 1. Critically, the two sides are reportedly picking up the nearly completed draft text of a trade agreement that was abandoned in May when divisions over compliance and tariffs resulted in a breakdown. Trump and Xi Jinping have an occasion to meet in Santiago, Chile in November, which is the best time for a signing if the talks progress well. Trump fired his hawkish National Security Adviser, John Bolton. Bolton was a supporter of the president’s “maximum pressure” foreign policy toward rivals, including China as well as Iran and North Korea. Oil prices dropped on the expectation that U.S. relations with Iran could improve, easing oil sanctions and increasing supply (Chart 3). But ultimately the signal is bullish for oil. The real significance is not Bolton himself but rather that Trump is changing tack to reduce geopolitical risks to economic growth. Whoever replaces Bolton is far less likely to be an uber-hawk (Bolton had cornered that market). A trade deal with Japan has been agreed in principle and may be signed in late September. U.S. relations with Europe are marginally improving. Trump even sent Secretary of State Mike Pompeo on a trip to discuss a diplomatic “reset” with the EU’s new crop of leaders set to take power in November and December. These improvements are tentative. Trump still explicitly rejects the idea that he should court Europe to apply unified pressure on China. But his administration has agreed to a beef export deal with the EU and, as long as China talks are ongoing, he is unlikely to slap tariffs on European cars. This decision will likely be postponed beyond November 14. All of the above confirms that Trump is focused on reelection. But how can we be sure this less-hawkish policy turn will last longer than five minutes? Rising unemployment is the most deadly leading indicator of a president’s approval rating. Economic data is alarming for a sitting president. Following a drop in business sentiment and investment, consumer sentiment is now suffering (Chart 4). Manufacturing – the sector Trump was ostensibly elected to defend – has slipped into outright contraction and loans and leases are shrinking in the electorally vital Midwestern states (Chart 5). Chart 3Bolton Bolting Is Bullish For Brent Bolton Bolting Is Bullish For Brent Bolton Bolting Is Bullish For Brent Chart 4A Reason For Trump To De-Escalate A Reason For Trump To De-Escalate A Reason For Trump To De-Escalate Fortunately for Trump, the job market is showing signs of resilience, with initial unemployment claims dropping hard (Chart 6). Chart 5Another Reason For Trump To De-Escalate Another Reason For Trump To De-Escalate Another Reason For Trump To De-Escalate Chart 6Good News For Trump Good News For Trump Good News For Trump Chart 7U.S. Consumer Should Prevent Recession U.S. Consumer Should Prevent Recession U.S. Consumer Should Prevent Recession BCA does not expect a recession within the next 12 months. The American consumer remains buoyant and median family incomes are strong (Chart 7). Nevertheless, Trump cannot assume anything. The proliferation of the “R” word has a negative psychological effect on businesses and consumers that could create a negative feedback loop. It also raises the risk of an equity selloff that tightens financial conditions and exacerbates the slowdown (Chart 8). Trump’s Democratic opponents and much of the news media will amplify negative economic news. Chart 8Trump Needs To Change The Topic Trump Needs To Change The Topic Trump Needs To Change The Topic While Trump cares about the stock market, his election ultimately rests on voters, not investors. Even if recession is avoided, a rising unemployment rate would be the most deadly leading indicator of a sitting president’s approval rating (Charts 9A & 9B). It is a far more telling variable than income growth or gasoline prices, for example. Chart 9APresidential Approval... Presidential Approval... Presidential Approval... Chart 9B...Follows Unemployment ...Follows Unemployment ...Follows Unemployment As Charts 9A & 9B demonstrate, unemployment and presidential approval are not always tightly correlated. Rather, for all recent presidents, the direction of unemployment ultimately prevailed over the approval rating by the time of the election – it pulled approval up or down in the final lap of the term in office. Moreover Trump, a bull-market president, is one of the cases where the approval rating is indeed tightly correlated with unemployment, as with Bill Clinton. And he is particularly vulnerable because his approval is historically weak and the unemployment rate can hardly fall much further from today. Granting that Trump is now going to adopt a more pro-market foreign and trade policy orientation, the next question is: what will that entail? Bottom Line: Trump’s tactical policy retreat is materializing which means that geopolitical risk stemming from U.S. foreign and trade policy is declining on the margin. While Trump is unpredictable, his sensitivity to the drop in his polling and weakening economy shows he wants to be reelected. Hence policy will have to moderate. Bolton Bolts – Geopolitical Risks Abate Trump’s ousting of his National Security Adviser Bolton is an important sign of the less-hawkish shift in administration policy. The ouster itself is not surprising in the least. Trump ran for office on a relatively isolationist foreign policy of non-intervention, withdrawal from long-running wars, and eschewing regime change and foreign quagmires to focus on America’s commercial interests. By contrast Bolton is perhaps the Republican Party’s most outspoken war hawk – a neo-conservative of the Bush era who advocated regime change in North Korea and Iran. This position was always at odds with Trump’s eagerness to negotiate and strike deals with the world’s dictators in the name of trade and riches rather than war and expenses.1 Chart 10Will Xi Sell Pyongyang For Washington? Will Xi Sell Pyongyang For Washington? Will Xi Sell Pyongyang For Washington? The immediate implication is that the U.S. and Iran will reduce tensions. We will address this topic at length next week, but the gist is that Trump is much more likely to relax sanctions and hold a summit with Iranian President Hassan Rouhani now than before. This is in keeping with our view that the China trade war is a far greater geopolitical risk than the U.S.-Iran tensions post-withdrawal from the 2015 nuclear pact. However, Bolton’s firing is bullish for oil prices. Iran may still stage low-level provocations that threaten supply, but Saudi Arabia has also appointed a new energy minister in preparation for an OPEC 2.0 strategy that aims to bolster prices in the advance of the initial public offering of Aramco.2 At the same time, Trump’s softening foreign policy stance portends an improvement to the global economy. Nowhere is this clearer than with North Korea and China. Kim Jong Un has explicitly demanded Bolton’s replacement to get talks back on track – Trump has now met this demand. North Korea has also been an integral component of the U.S.-China negotiations throughout Trump’s administration. If Trump’s diplomacy succeeds with North Korea, markets will rightly conclude that U.S.-China tensions are falling. China has an interest in denuclearizing the peninsula, which ultimately entails getting rid of U.S. troops, so it has shown it can comply with U.S. sanctions (Chart 10). A third Trump-Kim summit that results in a nuclear deal of any kind would be a concrete policy win for Trump and a strategic win for China.   The North Korean threat itself is not market-relevant – war risk peaked in 2017 (Chart 11). But an official agreement would provide an “off-ramp” for U.S.-China trade tensions. It would boost trade talks enough to improve global sentiment, and it could even increase the chances that the two countries conclude a deal involving tariff rollback. A Trump-Kim agreement would provide an “off-ramp” for U.S.-China trade tensions. Bolton’s ouster could also smooth U.S.-China tensions over Taiwan – he was an outspoken hawk on this front as well. His presence encouraged fears in Beijing that the Trump administration was planning a significant upgrade in Taiwan relations. These apprehensions were already high from the moment Trump accepted President Tsai Ing-wen’s congratulations on his election in 2016. It remains to be seen whether Trump will delay an $8 billion arms sale that will be the biggest since 1992 (Chart 12) – China has threatened to sanction U.S. defense firms if it goes ahead. But postponement is more likely now than before. This would help along the trade talks. Chart 11North Korea: 'Off-Ramp' For US-China Tensions North Korea: 'Off-Ramp' For US-China Tensions North Korea: 'Off-Ramp' For US-China Tensions Chart 12Will Trump Sell Taipei For Beijing? Trump's Tactical Retreat Trump's Tactical Retreat The direction of Taiwan in the near term partly depends on the direction of Hong Kong. Bolton likely advised a hard line in defense of the mass pro-democracy protests, which Trump was inclined to neglect for the sake of the trade talks with Beijing. Unless a mainland intervention and bloody security crackdown occurs – which is still a risk, and would make it politically impossible to conclude a trade deal with China – Trump will probably continue to sideline this Special Administrative Region. The jury is still out on whether protests will escalate after China’s National Day celebration, but Bolton’s absence and Hong Kong’s concessions to the protesters (which are backed by Beijing) are both positive signs. All of these factors suggest that the odds of a U.S.-China trade deal by November 2020 should rise. But is that really the case? For now we are maintaining our view that the odds are 40% by November 2020, though the risks are to the upside. Chart 13Trump Can Partially Offset China Tariffs Trump Can Partially Offset China Tariffs Trump Can Partially Offset China Tariffs While Trump and Xi can certainly make an executive decision to agree to a deal – any deal – we maintain our high-conviction view that it will lack durability due to uncertainties regarding compliance on China’s side and faithfulness on Trump’s side. And a shallow deal may be politically untenable if markets and the economy rebound. Crucially, neither China’s economic data nor U.S. financial conditions are forcing either side to capitulate entirely. Trump’s policy retreat entails the removal of trade risks from Canada, Mexico, and Japan first and foremost, and likely the European Union. This will offer some consolation to markets even though the small increase in U.S. exports in the near-term will not offset the sharp drop in exports to China (Chart 13). Combined with a de-escalation and containment of tensions with China, and worldwide monetary and fiscal stimulus, markets will face a substantial policy improvement. This will actually reduce the incentive for a final trade deal. If financial and economic pressure intensify and the U.S. heads toward a technical correction or bear market, Trump will need to capitulate. This will require significant tariff rollback. At that point, Xi Jinping will have the opportunity to agree to a short-term deal based on China’s current concessions and nothing more (Table 1). This would demonstrate to the whole world that it does not pay to coerce China: China operates on mutual respect and win-win agreements. This would be acceptable to Xi Jinping since it would at least buy some time until the inevitable second round of the strategic conflict in 2021. But we are not at full capitulation yet. Table 1China’s Offers Thus Far In The Trade War Trump's Tactical Retreat Trump's Tactical Retreat Bottom Line: Trump’s policy retreat includes the ouster of Bolton, which deescalates geopolitical risk on several fronts. Nevertheless, none of these risks – Iran, China, North Korea, Hong Kong, Taiwan – is fundamentally resolved. A U.S.-China trade agreement is not even necessary if the two political leaders are sufficiently supported by positive global macro developments. We continue to believe North Korea will lead to Trump diplomatic successes. De-escalation could lead to a breakthrough in trade talks pointing toward a deal, but it could also simply create an “off ramp” for the U.S. and China to contain tensions without having to capitulate on the trade front. Warren Still Warrants Caution While geopolitical risk has some room to abate, domestic political risk in the U.S. will pick up the slack. The entire American election cycle will trouble the markets over the coming 12 months – particularly due to the high chances of significant social unrest. Yet the greatest risks are frontloaded in the form of the Democratic Primary contest. This is because Warren will continue to do well in the early primary debates and therefore could soon morph into the biggest market risk of the entire election cycle. To be clear, her position as the frontrunner in the online betting markets is not validated by the national or state-level opinion polling. Biden remains dominant (Chart 14). If he stays firm above a 30% support rate, with double-digit leads over his nearest competitors in a range of important states, his chances of winning will rise over time and market uncertainty will fall. Chart 14Biden Still The Frontrunner In Democratic Primary Trump's Tactical Retreat Trump's Tactical Retreat While Biden’s election would be market-negative on the margin due to the outlook for tax hikes and re-regulation, Trump’s reelection is not as market-positive as some may believe since he will be unbridled in his second term and more capable of pursuing his aggressive protectionism. Ultimately, the choice between Trump and Biden is a choice between two candidates whose policies and flaws are well known and relatively digestible by markets. If Warren or Sanders come close to the Oval Office, the equity market will go through a re-rating. On the contrary, if Warren surpasses Sanders and takes the lead, uncertainty will skyrocket regardless of Trump’s advantages in the general election. This is not unlikely, as the leftward lurch within the party continues to propel the progressive candidates upward in the contest (Chart 15). If Warren or Sanders are seen as coming within one step from the Oval Office, the equity market will have to go through a re-rating. These progressive populists are proposing an onslaught of laws and regulations against banks, health insurers, oil and gas drillers, and the tech oligopoly. The agenda is inherently negative for corporate earnings in these sectors, as Peter Berezin of BCA’s Global Investment Strategy shows in a recent report.3 Chart 15Progressive Consolidation Would Increase Market Angst Trump's Tactical Retreat Trump's Tactical Retreat Chart 16Stocks Will Start To Trade On Polls Stocks Will Start To Trade On Polls Stocks Will Start To Trade On Polls Health stocks are clearly reacting to Warren’s surge in the online betting markets (Chart 16), so any convergence of the polling of real voters to these probabilities will cause a reckoning in this sector as well as in other sectors she has targeted, like financials, technology, and energy. The saving grace for now – a reason we remain cyclically bullish – is that Biden has not yet broken down in the polling. He is the least market-negative of the top three candidates, yet the most electable from the point of view of the swing state polling and electoral-college calculus. Warren is the most market-negative yet least electable of the top three. She must decisively surpass Sanders in order to create lasting volatility. Yet this will be hard to do because his electoral-college path to the presidency is clearer than Warren’s, judging by head-to-head polls with Trump, and he has the machinery and motivation to slog through the primary race for a long time – which undercuts both him and Warren versus Biden. Warren and Sanders are also less likely to lead the Democrats to victory in the senate even if they take the White House due to their lack of appeal in key senate races like Arizona and Georgia. Without a majority in the senate, their radical policy agenda will have to be left at the door. Investment Implications We are booking gains on our long spot gold trade at 16% since initiation. The thesis remains sound and we will reinitiate when appropriate.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Bolton’s tenure with Trump began with an incredible faux pas in which he advocated “the Libyan model” for the administration’s North Korean policy – prompting Trump to overrule him and reject that model. No comment could have been more inappropriate for a president trying to build trust with Kim Jong Un to sign a denuclearization deal. Libyan dictator Muammar Gaddafi was killed by enemy militias in Libya after NATO warplanes bombed his convoy – NATO’s intervention occurred despite Gaddafi’s having abandoned his nuclear weapon program in the wake of the September 1, 2001 attacks to avoid conflict with the U.S. and its allies. 2 See BCA Commodity & Energy Strategy Weekly Report, “Ignore The KSA-Russia Production Pact, Focus Instead On Their Need For Cash,” September 8, 016, ces.bcaresearch.com. 3 See BCA Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” September 1, 2019, gis.bcaresearch.com.

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

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

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