Geopolitics

Dear Client, I am travelling this week so this report is a joint effort juxtaposing two contrasting observations about France. The ‘opulence’ part highlights France as the world’s dominant producer of luxury goods, and makes the case that some of the French luxury goods companies should form a core part of a long-term investment portfolio. The ‘rebellion’ part borrows from a recent Special Report on French politics penned by my colleague Jeremie Peloso. It analyses the recent yellow vest protests in France, and assesses whether they are a cause for concern. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Opulence Made In France Global luxury goods sales amount to a quarter of a trillion dollars, and Europe dominates in the production of these luxury goods. Measured by the number of companies, the leading luxury goods country is Italy. But on the more important metric of share of total global sales, the undisputed world leader is France. In fact, just four French companies produce a quarter of the world’s luxury goods sales. The four are: LVMH, Kering, L’Oreal, and Hermes1 (Chart of the Week, Chart I-2, and Table I-1). France’s luxury goods sector is an excellent diversifier for investors. This is because, compared to other goods and services, luxuries follow very different laws of economics: The demand for luxuries has a positive elasticity to price. Put more simply, the desirability of a luxury increases as its price goes up. This is opposite to the demand for non-luxuries which has a negative elasticity to price: for non-luxury items, the demand declines as the price goes up. By definition, you cannot compete with a luxury item by undercutting its price. Given that a luxury implies fine-craftsmanship rather than mass production, the sector is highly resilient to the existential threats confronting other European industries that emanate from out-sourcing to lower cost economies and from automation. Luxury demand is also relatively insensitive to exchange rate movements. The barrier to entry into the luxuries sector is extremely high. It takes years, or even decades, for a luxury item to acquire its premium status based on consistent high quality in materials and craftsmanship. This high barrier to entry makes it much harder for other economies to challenge the European and French dominance in providing these luxury products. Despite these attractive characteristics the sector does still require a source of structural demand. Our premise, expounded in our Special Report “Buying European Clothes: An Investment Megatrend”, is that the feminisation of consumer spending, particularly in Europe, is providing a strong structural tailwind to the demand for ‘soft’ luxury goods. A recent industry study by Deloitte corroborates this thesis, pointing out that the strongest growth in the luxury sector is to be found in cosmetics, fragrances, bags and accessories. On this premise, the four leading French companies are big beneficiaries.2,3   Are market valuations already aware of, and fully discounting, the thesis of feminisation of consumer spending? We think not, as most investors are surprised by the thesis and unaware of the on-going dynamics behind it. On this basis, three of the four French luxury companies, trading on forward PE multiples in the 20s or below, still appear reasonably valued for their growth prospects (Table I-2). The exception is Hermes which, on a multiple of 40, does seem richly priced. The bottom line is that the three other leading French luxury goods companies – LVMH, Kering, and L’Oreal – do deserve to be a core part of a long-term investment portfolio. Rebellion Made In France The yellow vest protest movement is not a coherent force led by a clear leadership. What started on the social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. 77 percent of respondents in a recent poll view him as the “president of the rich.” The modification of the ‘wealth tax’ – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favouring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth on the back of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart I-3). Chart I-3What Income Inequality? Public support for the protests has hovered consistently around 70 percent since they started in November 2018 (Chart I-4). However, there are now more respondents who think that the protests should stop as that they should continue (Chart I-5). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.4 Who are the yellow vests? They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the centre (Diagram I-1). How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, the numbers countrywide are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart I-6). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table I-3). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart I-7). We would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. Thus the yellow vests should not have a major impact on Macron’s reform agenda. As expected, Macron has not mentioned changing course on his most business-friendly reforms, which we see as a signal to investors that, despite the recent chaos, the plan remains the same. There is no strategic reason why Macron would reverse course. His popularity is already in the doldrums. His only chance at another term is to plough ahead and campaign in 2022 on his accomplishments. Nevertheless, to ensure that he does not plough into a rock, Macron will adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. In a similar vein, pension reforms will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one having its own rules of calculation. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards, it might be too risky for the government to push the pension reform so close to these events. Such adjustments to the reform agenda should help reduce the protest movement’s fervour or otherwise its support. The bottom line is that the yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward.5   Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 In the case of L’Oreal this refers to the L’Oreal Luxe division. 2  Please see the European Investment Strategy “Buying European Clothes: An Investment Megatrend”, dated December 6, 2018 available at eis.bcaresearch.com. 3 Deloitte: Global Powers of Luxury Goods 2018, Shaping the future of the luxury industry 4 According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 5 For the full report, please see the Geopolitical Strategy Special Report “France: La March A Suivre?”, dated February 27, 2019, available at gps.bcaresearch.com.  

Special Report

Highlights So What? Optimism over a U.S.-China trade deal is becoming excessive. Why? Presidents Trump and Xi appear to want a deal but their late March summit is not yet finalized. Several news reports supporting the bullish consensus are overrated. The odds of a “grand compromise” that entails China implementing U.S. structural demands are 10%. The odds of trade war escalation are 30%. China’s policy stimulus is a better reason than trade talks to become more constructive on Chinese and China-sensitive risk assets. Feature The Chinese equity market is rallying enthusiastically as the annual “Two Sessions” legislative meeting convenes (Chart 1). The basis for the rally is evidence of greater policy support for the economy along with a general belief that the U.S. and China are close to concluding a trade deal, possibly at a fourth summit between President Donald Trump and Xi Jinping that may be held in late March. The NPC session will build on the optimism with Premier Li Keqiang’s promise of more “forceful” policy support and the passage of a new foreign investment law that promises fair treatment to foreign companies. Chart 1Positive Trade Signals, But Market Getting Ahead Of Itself Our view is that the trade signals are broadly positive – implying a 70% chance that tariffs will either remain frozen or decrease in the scenario analysis below – but that the market is getting ahead of itself both in terms of the likelihood of a “structural deal” and in terms of the positive market impact from any deal. The market impact will depend on the depth of the concessions that China offers the United States. If the concessions are significant, President Donald Trump will be able to roll back tariffs to a considerable extent – trade policy uncertainty will fall, China’s economic outlook will improve, and Trump’s reelection odds (and hence U.S. economic policy continuity) could increase marginally. If China’s concessions are slight, tariff rollbacks will be limited or non-existent and the deal will stand on shaky ground, ensuring elevated policy uncertainty in the aftermath of the agreement and raising the probability of a relapse into trade war ahead of the 2020 election. Trump may feel he has to prove his protectionist credentials anew against a trade critic in the general election. Will the outcome be positive enough to surprise Chinese and global markets that have already discounted a lot of positive news? From where we sit, this is unlikely. More likely, investors will be underwhelmed by a lack of resolution or the shallowness of a deal. The risk to this view is the aforementioned structural deal that involves substantial Chinese concessions combined with a major reduction in U.S. tariffs and sanctions. But even in this case investors will face additional trade uncertainty relating to the U.S. Section 232 investigation into auto imports, on which Trump must decide by May 18, underscoring the point that trade alone is not a firm basis for bullish investment recommendations over the course of H1 2019. The continued strength of the U.S. economy and China’s policy stimulus provide a more realistic basis for global risk assets to rally over the 6-12 month horizon. Presidential Momentum For A Trade Deal We remain pessimistic about U.S.-China relations in general and the prospects for a structural trade deal in particular. This is reflected in our subjective trade-deal probabilities, which hold that an additional extension is as likely as a final deal this month and that the risk of a relapse into trade war remains elevated at 30% (Table 1). Table 1Updated Trade War Probabilities Fundamentally, our pessimism stems from our view that the U.S. and China are locked in the early chapters of an epic struggle for supremacy in Asia Pacific that will reduce their ability to engage cooperatively (Chart 2). Chart 2China, U.S. In Geopolitical Power Struggle Critically, the economic impact of a trade war is not prohibitive for either country. China is not as reliant on exports as it once was. In addition, neither the U.S. nor China is too reliant on trade with the other to make a trade war unthinkable, as was the case with Canada and Mexico (Chart 3). Chart 3Economic Impact Of A Trade War Is Not Prohibitive China is economically vulnerable but is politically centralized, as symbolized by Xi Jinping’s aggressive purge of the Communist Party on the basis of corruption (Chart 4). The ruling party can and will accept the worst international economic outcomes since 1989-91, if it believes this is necessary for regime survival. Chart 4Regime Survival is Paramount Meanwhile the U.S. is economically insulated and performing relatively well (Chart 5), and is not politically divided on the question of China. A bipartisan, hawkish consensus has developed that will be discussed below. Just as we argued correctly that this trade war would occur, so too we believe it has a fair chance of reigniting. This could be due to policy miscalculation, unforeseen events, or the likelihood that Trump will face heat from the left-wing ahead of the election if he gives China as easy of a deal as he gave to Canada. Chart 5The U.S. Economy Is Strong But Softening... Nevertheless we accept that there is top-level momentum in favor of a deal for the time being, and this comes from both Presidents Trump and Xi. In China, delaying tactics are the standard way of coping with an angry Washington, as the perception in Beijing is that economic and technological advancement give it greater leverage over time. Moreover, the economy is weakening on several fronts, private sector sentiment is bearish, and the easing of fiscal and monetary policy is of unclear effectiveness (Chart 6). These are all reasons for Xi to seek at least a temporary reprieve. Chart 6...While the Chinese Economy Is Weak But Stimulating In the United States, Trump faces a difficult election campaign due to his relatively low job approval with voters (Chart 7). His polling has recently improved with the settlement of the FY2019 budget and avoidance of a second government shutdown, and this is despite his controversial decision to press forward unilaterally on southern border security. But he will be running for office late in the business cycle and is vulnerable to an equity bear market and recession. This explains why he has shown risk aversion since October on market-relevant issues ranging from NAFTA, Iran, and China. A trade deal with China offers the possibility not only of satisfying a campaign promise (renegotiating the terrible trade deals of the past) but also of a substantial boost to investor sentiment and key parts of the U.S. economy via Chinese cash. Thus it is reasonable to assess that Trump and Xi can satisfy their political preference for a deal in the short run. If Xi does not gratify Trump’s campaign platform as a great deal-maker, he will give impetus to Trump to form a grand protectionist coalition. Such a coalition could eventually succeed in constricting China’s technological development, as exemplified by the U.S.’s campaign against Chinese telecoms equipment maker Huawei. Fundamentally, China still depends on the West for the computer chips that are essential building blocks for its manufacturing sector (Chart 8). However, while this is a reason for Xi to play ball, it is far from clear that Xi will rapidly implement deep structural changes demanded by the United States. Xi has good reason to fear that Trump will continue the tech war on national security grounds despite any trade deal. Plus, either Trump or a Democratic president could take new punitive trade measures after 2020, given the underlying strategic struggle. For these reasons China is likely to slow-walk any structural concessions. We recognize that our 35% probability that trade talks will be extended cannot last forever. Assuming that Trump and Xi confirm the time and place of a fourth summit, the probability of some kind of deal will rise toward 70%. We doubt very much that Trump and Xi will attend such a summit without a high degree of confidence in the outcome, unlike the Trump-Kim summit in Hanoi, which suffered from inadequate preparation. Yet even if the probability of a deal rises to 70%, we still think there would remain a 30% chance of either an unexpected extension or a disastrous breakdown in negotiations – and we are not yet at that 70% mark. Bottom Line: Until a Trump-Xi summit is finalized in the context of continued progress in trade negotiations, we maintain our pessimistic probabilities for the trade negotiations, with a 30% chance of total collapse and a 35% chance of a further extension of talks beyond March. Remain Vigilant On The Trade Talks It is debatable whether momentum in favor of a U.S.-China trade deal has increased over the past two weeks as much as the news flow suggests. First, Trump’s extension of the tariff deadline – which he originally envisioned as a pause for a month “or less” – could just as easily lead to additional extensions rather than a quick resolution. This will be clear if a Trump-Xi summit does not materialize in late March. A logical time for the two to meet would be at the G20 summit in Osaka, Japan on June 28-29, which would prolong the trade policy uncertainty for nearly four months from today. Second, reports suggest that China, like the EU, is demanding that all Trump’s tariffs be removed as part of any trade deal. If true, this demand is more likely to result in a failure to make a deal than a total tariff rollback. The reason is that the U.S. needs to retain the ability to adjust Section 301 tariffs based on China’s actual degree of implementation of any commitments it makes to reduce forced technology transfers, economic espionage, and intellectual property theft. Several of these commitments are enshrined in the new foreign investment law that would pass through China’s legislature over the next two weeks (Table 2), but the U.S. will want to ensure that the law is actually implemented. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations If the U.S. rolls back all Section 301 tariffs it will lose a convenient legal standing from which to dial the tariffs back up if necessary. It is more likely that part or all of the 10% tariff on $200 billion worth of goods will be rolled back (our short-term trade deal scenario with 25% odds) than that the entire Section 301 tariffs will be rolled back (our best-case trade deal scenario with a 10% probability). The degree of rollback will be a critical indicator of the durability of any deal, as it will make a material difference for China’s export-manufacturing outlook (Chart 9). Thus far, China’s economy has counterintuitively benefited from the trade war due to tariff front-running. Chart 9The Degree Of Tariff Rollback Matters Third, the disagreements between President Trump and his hawkish lead negotiator, U.S. Trade Representative Robert Lighthizer, are likely overstated in their ability to increase the odds of finalizing a deal. There are two arguments for the view that Trump is losing faith in Lighthizer. The first is that he blames Lighthizer’s tough tactics for the equity market selloff. This may not be valid given that stocks continued to sell off after Trump sided with the trade doves and agreed to a trade truce with Xi Jinping. In December the S&P 500 suffered the worst monthly performance since February 2009 and the worst December performance since 1931. The second argument is more substantial and comes from Trump’s public interchange with Lighthizer over the use and value of memorandums of understanding (MOUs). The interchange was awkward and suggests that tensions exist between Trump and his top negotiator.1 However, the episode may have an important implication. Whatever the reason for the disagreement, Lighthizer gained the assent of two Chinese negotiators – Vice Premier Liu He and U.S. ambassador Cui Tiankai – in his declaration, on camera, that the term MOU would be dropped in preference for the term “trade agreement.” The result is that while the deal is still not going to be a “Free Trade Agreement” that requires legislative ratification, the language of the final document will be if anything more, not less, binding. This episode cannot possibly accelerate a final deal. It is hard to believe that Lighthizer is not secretly happy with the result of his dust-up with the president. It is well known – and frequently complained about by Lighthizer and other Trump administration officials – that China has very active diplomacy and makes many international agreements that are more nominal than real in their results. As a simple example, China typically agrees to a larger value of outbound investment than is ultimately realized (Chart 10). In fact, Lighthizer is at the forefront of the administration’s repeated and explicit aim to pin China down to better implementation and enforcement of any agreement. Indeed, in both of Lighthizer’s reports on the Section 301 investigation that motivate the tariffs, he refers to a well-known September 2015 commitment, between President Xi and former U.S. President Barack Obama, not to conduct cyber-espionage against each other’s countries. Lighthizer shares the view of the broader U.S. political establishment that China only temporarily enforced this commitment and later ramped up its hacking to steal trade secrets.2 Chart 10China Known For Overpromising Fourth, Trump’s failure to conclude a peace and denuclearization deal with North Korean leader Kim Jong Un in Hanoi, Vietnam does not increase the odds of a U.S.-China deal – it is either neutral or negative for U.S.-China talks. Whether intentional or not, the summit reminded the Chinese that Trump’s “art of the deal” requires the willingness to walk away from a bad deal. As mentioned, we view the odds of Trump walking away from a China deal at 30%. But the deeper problem is that Trump expects China’s assistance with North Korea as a condition of the trade deal. Whenever Trump thinks that China is not providing enough assistance, he threatens to walk away from talks with Kim. This occurred in May 2018 and has apparently occurred again. The failure of the summit is a failure of U.S.-China diplomacy in the sense that China could not or would not convince Kim Jong Un to offer more concrete steps toward denuclearization. This reflects negatively on the trade talks if it reflects anything at all. Bottom Line: Aside from the presidential momentum behind a trade deal, none of the recent news reports or leaks form a basis for upgrading the probability of a final agreement in late March. Will It Be A “Structural Deal”? Lighthizer is not isolated in driving a hard bargain with China: he enjoys the support of both parties in the U.S. Congress. At his recent testimony on U.S.-China trade to the House Ways and Means Committee, bipartisanship was a key theme. Democrats as well as Republicans voiced support for Lighthizer as the top negotiator due to his strict stance on China’s trade practices, while Lighthizer himself praised both Trump and Democrats such as House Speaker Nancy Pelosi for being skeptical about China’s trade practices as far back as 2001. The takeaway is that Trump needs deep concessions from China – what the top Democrat on the committee called “a structural deal” – in order to defend any trade deal against domestic critics and skeptical voters on the campaign trail in 2020. In other words, there is unanimity in Congress, as there was in May 2018, that Trump should not sacrifice his leverage for a deal limited to Boeings and soybeans but should instead obtain victories on core disagreements: national security, foreign exchange rates, market access, and intellectual property. The MOUs – now “agreements” – that are reportedly being drafted address these core disagreements. Therefore signs of progress in producing final drafts should be seen as evidence that the odds of a final deal are improving: Forced tech transfers: Raising equity caps for foreign investment in key sectors is a headline way to reduce the leverage that Chinese companies have used to extract technology (Table 3). There are other arbitrary licensing and permitting practices that could also be curtailed. Table 3Foreign Investment Equity Caps Intellectual property: China’s purchases of U.S. intellectual property are conspicuously small, especially when considering that China is not yet an innovation giant in terms of international IP licensing receipts relative to the amount that it pays out.3 If the U.S.’s IP trade balance with China were equivalent to its balance with South Korea, it would result in a $36.7 billion improvement in the U.S. balance (Chart 11). Services: China is a major growing market for U.S. service exports but Washington frequently complains about denial of market access, for instance in financial and legal services. Services exports also underscore the above point about intellectual property (Chart 12). Foreign exchange: The U.S. is asking China not to maintain a more market-oriented currency but rather to promote a stronger currency relative to the dollar, perhaps referring to the yuan’s undervaluation according to purchasing power parity (Chart 13). It is impossible for Trump to accept a deal that does not include some text on the currency since he has hammered the issue of Chinese currency manipulation on the campaign trail and is trying to talk down the greenback. South Korea agreed to a currency annex and Japan is likely to do the same, and that makes it even less feasible for China to get off the hook. Non-tariff barriers: The U.S. has a long roster of complaints about China’s trade practices, including subsidies to state-owned companies, dumping, and inadequate health, environmental, and labor standards. Changing these practices will raise the costs of production in China. Changes to non-tariff barriers can also increase American market access in a way that goes beyond the simultaneous demands for lower tariffs on U.S. imports (Chart 14). Chart 13China Not Off The Hook On Currency Manipulation If China pledges improvements on these issues then it could justify substantial tariff rollback, perhaps the entire 10% tariff on $200 billion. This scenario, the best version of our 25% trade deal scenario, would comprise a positive surprise for markets in the current environment. It still could fall short of a grand bargain justifying a total tariff rollback, unless implementation is swift and decisive, which is highly improbable. A lesser but still market-positive surprise would be an American agreement to reduce pressure on Huawei (comparable to the deal reached in May 2018 on that other besieged Chinese tech company, ZTE). Still less positive outcomes would be a partial reduction in the tariff rate or an American agreement to expand or expedite exemptions to existing tariffs. The last would indicate relatively low expectations about the depth of China’s concessions. Bottom Line: Until the actual details of any Chinese structural concessions and American tariff relief are known, the durability of any U.S.-China trade deal cannot be assessed. This warrants at best cautious optimism regarding the trade talks: the two sides are working on draft texts about the right things. Investors will not be positively surprised by an agreement that does not include structural concessions of the nature above as well as substantial American tariff rollback, which is needed to verify American confidence in China’s commitments. Investment Implications The outcomes that are currently available to investors leave substantial room for prolonged trade policy uncertainty (Chart 15). Any further extension of trade talks means that uncertainty will persist at current levels. A deal that includes limited structural concessions means that uncertainty will ease but remain elevated relative to pre-2018 levels, due to the persistent threat of Section 301 tariffs that the U.S. will wield in order to secure Chinese concessions. A failure of negotiations means a dramatic escalation in uncertainty; this is our 30% risk due to the geopolitical and technological struggle underway. We allot only a 10% chance to a grand bargain that includes deep structural reforms and full tariff rollback. Chart 15Trade Uncertainty Will Persist As a final consideration, investors should be aware that the better the U.S.-China trade deal, the higher the probability that Trump imposes tariffs on auto and auto part imports pursuant to the Section 232 investigation into the impact of these imports on national security, which concluded February 17. The Commerce Department’s recommendations are still unknown but it is not a stretch to imagine that the administration has discovered a national security threat. However, this determination alone does not require Trump to impose tariffs. If he is to impose, he has until May 18 to do so. The full value of U.S. auto and auto parts imports is larger than the value of Chinese imports that currently fall under Trump’s tariffs. It is very unlikely that the U.S. will match this size of tariffs against the EU (Chart 16). Certainly it will not do so if the U.S.-China conflict remains unresolved, since it seems a stretch to believe the equity market can sustain both trade wars at the same time. The Trump administration has already found that the China tariffs without negotiations were disruptive to the U.S. equity market and economy, and the U.S. has told the European Union and Japan that it will not impose tariffs as long as negotiations are underway. To do so would be practically to foreclose the possibility of a trade agreement prior to the 2020 election, at least in the case of the EU. Thus it is only after any U.S.-China deal that the risk of EU impositions rises. We take the view that Japan is likely to conclude an agreement with the Trump administration quickly, possibly even before the China deal but almost certainly shortly afterwards. Trump administration officials will also likely intervene on behalf of South Korea due to the strategic need to stay on the same page regarding North Korea, which itself led to the successful renegotiation of the two countries’ existing trade agreement last year (which included autos but did not explicitly exempt Korea from Section 232 auto tariffs). This leaves the EU, which is quarreling with the U.S. over a range of issues: trade, Iran, Russia, China, Brexit, Syria, etc. Our base case is that the U.S. will not impose sweeping Section 232 tariffs on the EU due to the negative impact this would have on the U.S. auto industry, which is rooted in the electorally critical Midwest; the aforementioned risk to the equity market and economy; and the fact that neither the U.S. public, nor Congress, nor the corporate lobby are supportive of a trade war with Europe. Tariffs would also harm the Trump administration’s broader attempt to galvanize Western countries against the strategic challenge of China, Russia, and Iran. Nevertheless, the risk of such sweeping tariffs is non-trivial because Trump does not face legal constraints in imposing them – he can act unilaterally, just as he did with the early Section 232 tariffs on steel and aluminum, which broadly remain in force. A negative trade shock to the EU at a time of economic weakness may not overwhelm the positive trade impact of a U.S.-China deal in the context of China’s policy stimulus, but it would take the shine off of any risk-on exuberance following a China deal. In the end, China’s risk assets are likely to continue benefiting from domestic policy stimulus plus the 70% likelihood that tariffs will not go up. BCA’s Geopolitical Strategy remains cyclically positive Chinese stocks relative to emerging market stocks over a 12-month horizon given China’s more robust stimulus measures and the above trade view. We are shifting our long China Play Index to a trade as opposed to a portfolio hedge. We are also long copper. We would anticipate that the trend for CNY-USD will be flat to up as long as negotiations proceed in a positive manner. BCA’s China Investment Strategy is tactically positive Chinese stocks relative to the global MSCI benchmark on the same basis, but is awaiting more evidence of a stabilization in the earnings outlook before recommending that investors shift to an outright overweight over the cyclical horizon. Still, our China team placed Chinese stocks on upgrade watch in their February 27 Weekly Report, signaling that the next change in recommended allocation is likely to be higher rather than lower.4   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com     Footnote 1 News reports had indicated that Lighthizer and his Chinese counterparts were negotiating six MOUs – on forced tech transfer and cyber theft, intellectual property rights, services, currency, agriculture, and non-tariff barriers to trade – in pursuit of the March 1 deadline. When asked about the time horizon of the MOUs at a public press conference with the Chinese trade delegation in the White House, President Trump said that MOUs were not the same as a “final, binding contract” that he wanted as an outcome of the talks. Lighthizer spoke up in defense of MOUs, leading the president to publicly disagree with him. Lighthizer then declared that the term “MOU” would no longer be used and instead the two sides would use the term “trade agreement.” 2 This was the same summit at which Xi Jinping declared in the Rose Garden that China had no intention to militarize the South China Sea – an even more frequently cited example of divergence between China’s official rhetoric and policy actions on matters of strategic consequence. 3 Please see Scott Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” CSIS, August 2017, available at www.csis.org. 4 Please see China Investment Strategy Weekly Report “Dealing With A (Largely) False Narrative,” dated February 27, 2019, available at cis.bcaresearch.com.

Highlights Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. Investors should overweight stocks and spread product while underweighting safe government bonds over a 12-month horizon. The U.S. dollar will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Stronger global growth and a weaker dollar in the back half of the year will benefit EM assets and European stocks. Feature I skate to where the puck is going to be, not to where it has been. — Wayne Gretzky How To Be A Good Macro Strategist To paraphrase Gretzky, a mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. How can one predict how the economic data will evolve? Examining forward-looking indicators is helpful, but it is not enough. One also has to understand why the data is evolving the way it is. If one knows this, one can then assess whether the forces either hurting or helping growth will diminish, intensify, or remain the same.  What Accounts For the Growth Slowdown? There is little mystery as to why global growth slowed in 2018. Chinese credit growth fell steadily over the course of the year, which generated a negative credit impulse. Unlike in the past, China is now the most important driver of global credit flows (Chart 1). Chart 1Global Credit Flows Are Increasingly Driven By China Meanwhile, the global economy was rocked by rising oil prices. Brent rose from $55/bbl on October 5, 2017 to $85/bbl on October 4, 2018. Government bond yields also increased, with the 10-year U.S. Treasury yield rising from 2.05% on September 7, 2017 to 3.23% on October 5, 2018 (Chart 2). Chart 2Rising Oil Prices And Bond Yields Contributed To Slower Global Growth Last Year A mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. In an ironic twist, Jay Powell’s ill-timed comment that rates were “a long way” from neutral marked the peak in bond yields. Unfortunately, the subsequent decline in yields was accompanied by a vicious stock market correction and a widening in credit spreads. This led to an overall tightening in financial conditions, which further hurt growth (Chart 3). Chart 3Financial Conditions Tightened In 2018, Especially After Powell's Hawkish Comments The critical point is that all of these negative forces are behind us: Financial conditions have eased significantly over the past two months; oil prices have rebounded, but are still well below their 2018 highs; and as we explain later on, Chinese growth is likely to bottom by the middle of this year. This means that global growth should start to improve over the coming months. The United States: Better News Ahead The latest U.S. economic data has been weak, with this morning’s disappointing ISM manufacturing print being the latest example. The New York Fed’s GDP Nowcast is pointing to annualized growth of 0.9% in the first quarter. While there is no doubt that underlying growth has decelerated, data distortions have probably also contributed to the perceived slowdown. For instance, the dismal December retail sales report reduced the base for consumer spending going into 2019, thus shaving about 0.4 percentage points off Q1 growth. The drop in real personal consumption expenditures (PCE) cut the New York Fed’s Q1 growth estimate by a further 0.15 percentage points. We suspect that much of the weakness in December retail sales and PCE was linked to the government shutdown. The closure caused some of the surveys used to compile these reports to be postponed until January, which is historically the weakest month for retail sales. The Johnson Redbook Index – which covers 80% of the retail sales surveyed by the Department of Commerce – as well as the sales figures from Amazon and Walmart all point to strong spending during the holiday season (Chart 4). Chart 4The December U.S. Retail Sales Report Was Probably A Fluke Fundamentally, U.S. consumers are in good shape (Chart 5). As a share of disposable income, household debt is over 30 percentage points lower than it was in 2007. The savings rate stands at an elevated level, which gives households the wherewithal to increase spending. Job openings hit another record high, while wage growth continues to trend upwards. Fundamentally, U.S. consumers are in good shape. Chart 5U.S. Consumer Fundamentals Are Solid The housing market should improve. Rising mortgage rates weighed on housing last year. However, rates have been declining for several months now, which augurs well for home sales and construction over the next six months (Chart 6). Chart 6Mortgage Rates Will Not Be A Headwind For U.S. Housing Activity Over The Next 6 Months While capex intention surveys have come off their highs, they still point to reasonably solid expansion plans (Chart 7). Rising labor costs and high levels of capacity utilization will induce firms to invest in more capital equipment, which should support business spending. Chart 7U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Government expenditures should also recover. By most estimates, the shutdown shaved one percentage point from Q1 growth. This is likely to be completely reversed in the second quarter. The End Of The Chinese Deleveraging Campaign? The popular narrative about weaker Chinese growth has focused on the trade war. While trade uncertainty undoubtedly hurt growth last year – and has continued to weigh on growth so far this year – most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Fixed investment spending in China is generally financed through credit markets. Chart 8 shows that the contribution of investment spending to GDP growth has declined in tandem with decelerating credit growth.   Most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Chart 8China: Deleveraging Means Less Investment-Led Growth Chinese credit growth has typically reaccelerated whenever it has dipped towards trend nominal GDP growth. We may have already reached this point (Chart 9). New credit formation came in well above expectations in January. Given possible distortions caused by the timing of the Chinese lunar new year, investors should wait until the February data is released in mid-March before drawing any firm conclusions. Nevertheless, it is starting to look increasingly likely that credit growth has bottomed. The 6-month credit impulse has already surged (Chart 10). The 12-month impulse should also begin moving up provided that month-over-month credit growth simply maintains its recent trend (Chart 11). Chart 9Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Chart 10A Rebound In The Chinese 6-Month Credit Impulse Chart 11The 12-Month Impulse Is Set To Turn Up On the trade front, President Trump’s decision to delay the implementation of tariffs on $200 billion in Chinese imports is a step in the right direction. Nevertheless, gauging whether the trade war will continue to de-escalate is extraordinarily difficult. There is no major constituency within the Republican Party campaigning for protectionism. It ultimately boils down to what one man – Trump – wants. Our best guess is that President Trump will try to score a few political points by “declaring victory” – deservedly or not – in his battle with China in order to pivot to more pressing domestic issues such as immigration. However, there can be no assurance of this, which is why China’s leaders are likely to prioritize growth over deleveraging, at least for the time being. They know full well that the only way they can credibly threaten to walk away from the negotiating table is if their economy is humming along. Europe: From Headwinds To Tailwinds? Slower global growth, higher oil prices, and a spike in Italian bonds yields all contributed to the poor performance of the European economy last year. Economic activity was further hampered by a decline in German automobile production following the introduction of more stringent emission standards. The good news is that these headwinds are set to reverse course. Italian bond yields are well off their highs, as are oil prices (Chart 12). German automobile production is recovering (Chart 13). In addition, the European Commission expects the euro area fiscal thrust to reach 0.40% of GDP this year, up from 0.05% of GDP last year (Chart 14). This should add about half a percentage point to growth. Finally, if our expectation that Chinese growth will bottom out by mid-year proves correct, European exports should benefit. If neither the political establishment nor the general public favor Brexit, it will not happen. Chart 12Headwind No More (I): Italian Bond Yields Chart 13Headwind No More (II): German Auto Sector Chart 14The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Brexit still remains a risk, but a receding one. We have consistently argued that the political establishment on both sides of the British channel will not accept anything resembling a hard Brexit. As was the case with the EU treaty referendums involving Denmark and Ireland in the 1990s, the European political elites will insist on a “No fair! Let’s play again! Best two-out-of-three?” do-overs until they get the result they want. Theresa May’s efforts to cobble together a parliamentary majority that precludes a hard Brexit, along with the Labor Party’s increasing willingness to pursue a second vote, is consistent with our thesis. Fortunately for the “remain” side, public opinion is shifting in favor of staying in the EU (Chart 15). Focusing on the minutiae of various timetables, rules, and regulations is largely a waste of time. If neither the political establishment nor the general public favor Brexit, it will not happen. We are short EUR/GBP, a trade recommendation that has gained 5.2% since we initiated it. We continue to see upside for the pound. Chart 15The ''Remain'' Side Would Likely Win Another Referendum Investment Conclusions Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. The dollar is a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 16). The greenback will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Chart 16The Dollar Is A Countercyclical Currency We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. We do not have a strong view on EM versus DM equities at the moment, but expect to shift EM to overweight once we see more confirmatory evidence that Chinese growth is stabilizing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. In conjunction with our expected upgrade on EM assets, we will move European equities to overweight. Stronger global growth will benefit European multinational exporters, while brisker domestic growth should allow the market to price in a few more ECB rate hikes starting in 2020. The latter will lead to a somewhat steeper yield curve which, along with rising demand for credit, should boost financial sector earnings (Chart 17). This will give European bank stocks a welcome boost. Chart 17Stronger Euro Area Credit Growth Will Boost Bank Earnings Japanese equities will also benefit from faster global growth, but domestic demand will suffer from the government’s ill-advised plan to raise the sales tax in October. As such, we do not anticipate upgrading Japanese stocks. We also expect the yen to come under some pressure as the BoJ is forced to maintain its ultra-accommodative monetary policy stance, while bond yields elsewhere move modestly higher.      Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com   Strategy & Market Trends* MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Bank Credit Analyst

  Highlights Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. Investors should overweight stocks and spread product while underweighting safe government bonds over a 12-month horizon. The U.S. dollar will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. Stronger global growth and a weaker dollar in the back half of the year will benefit EM assets and European stocks. Feature I skate to where the puck is going to be, not to where it has been.  — Wayne Gretzky Gretzky's Doctrine To paraphrase Gretzky, a mediocre macro strategist draws conclusions based solely on incoming data. A good macro strategist, in contrast, tries to figure out where the data is heading. How can one predict how the economic data will evolve? Examining forward-looking indicators is helpful, but it is not enough. One also has to understand why the data is evolving the way it is. If one knows this, one can then assess whether the forces either hurting or helping growth will diminish, intensify, or remain the same. What Accounts For The Growth Slowdown? There is little mystery as to why global growth slowed in 2018. Chinese credit growth fell steadily over the course of the year, which generated a negative credit impulse. Unlike in the past, China is now the most important driver of global credit flows (Chart I-1). Meanwhile, the global economy was rocked by rising oil prices. Brent rose from $55/bbl on October 5, 2017 to $85/bbl on October 4, 2018. Government bond yields also increased, with the 10-year U.S. Treasury yield rising from 2.05% on September 7, 2017 to 3.23% on October 5, 2018 (Chart I-2). In an ironic twist, Jay Powell’s ill-timed comment that rates were “a long way” from neutral marked the peak in bond yields. Unfortunately, the subsequent decline in yields was accompanied by a vicious stock market correction and a widening in credit spreads. This led to an overall tightening in financial conditions, which further hurt growth (Chart I-3). The critical point is that all of these negative forces are behind us: Financial conditions have eased significantly over the past two months; oil prices have rebounded, but are still well below their 2018 highs; and as we explain later on, Chinese growth is likely to bottom by the middle of this year. This means that global growth should start to improve over the coming months. The United States: Better News Ahead The latest U.S. economic data has been weak, with this morning’s disappointing ISM manufacturing print being the latest example. The New York Fed’s GDP Nowcast is pointing to annualized growth of 0.9% in the first quarter. While there is no doubt that underlying growth has decelerated, data distortions have probably also contributed to the perceived slowdown. For instance, the dismal December retail sales report reduced the base for consumer spending going into 2019, thus shaving about 0.4 percentage points off Q1 growth. The drop in real personal consumption expenditures (PCE) cut the New York Fed’s Q1 growth estimate by a further 0.15 percentage points. We suspect that much of the weakness in December retail sales and PCE was linked to the government shutdown. The closure caused some of the surveys used to compile these reports to be postponed until January, which is historically the weakest month for retail sales. The Johnson Redbook Index – which covers 80% of the retail sales surveyed by the Department of Commerce – as well as the sales figures from Amazon and Walmart all point to strong spending during the holiday season (Chart I-4). Fundamentally, U.S. consumers are in good shape (Chart I-5). As a share of disposable income, household debt is over 30 percentage points lower than it was in 2007. The savings rate stands at an elevated level, which gives households the wherewithal to increase spending. Job openings hit another record high, while wage growth continues to trend upwards. The housing market should improve. Rising mortgage rates weighed on housing last year. However, rates have been declining for several months now, which augurs well for home sales and construction over the next six months (Chart I-6). While capex intention surveys have come off their highs, they still point to reasonably solid expansion plans (Chart I-7). Rising labor costs and high levels of capacity utilization will induce firms to invest in more capital equipment, which should support business spending. Government expenditures should also recover. By most estimates, the shutdown shaved one percentage point from Q1 growth. This is likely to be completely reversed in the second quarter. The End Of The Chinese Deleveraging Campaign? The popular narrative about weaker Chinese growth has focused on the trade war. While trade uncertainty undoubtedly hurt growth last year – and has continued to weigh on growth so far this year – most of the weakness in the Chinese economy can be traced to the deleveraging campaign which started in 2017, long before the surge in trade flow angst. Fixed investment spending in China is generally financed through credit markets. Chart I-8 shows that the contribution of investment spending to GDP growth has declined in tandem with decelerating credit growth.   Chinese credit growth has typically reaccelerated whenever it has dipped towards trend nominal GDP growth. We may have already reached this point (Chart I-9). New credit formation came in well above expectations in January. Given possible distortions caused by the timing of the Chinese lunar new year, investors should wait until the February data is released in mid-March before drawing any firm conclusions. Nevertheless, it is starting to look increasingly likely that credit growth has bottomed. The 6-month credit impulse has already surged (Chart I-10). The 12-month impulse should also begin moving up provided that month-over-month credit growth simply maintains its recent trend (Chart I-11). On the trade front, President Trump’s decision to delay the implementation of tariffs on $200 billion in Chinese imports is a step in the right direction. Nevertheless, gauging whether the trade war will continue to de-escalate is extraordinarily difficult. There is no major constituency within the Republican Party campaigning for protectionism. It ultimately boils down to what one man – Trump – wants. Our best guess is that President Trump will try to score a few political points by “declaring victory” – deservedly or not – in his battle with China in order to pivot to more pressing domestic issues such as immigration. However, there can be no assurance of this, which is why China’s leaders are likely to prioritize growth over deleveraging, at least for the time being. They know full well that the only way they can credibly threaten to walk away from the negotiating table is if their economy is humming along. Europe: From Headwinds To Tailwinds? Slower global growth, higher oil prices, and a spike in Italian bonds yields all contributed to the poor performance of the European economy last year. Economic activity was further hampered by a decline in German automobile production following the introduction of more stringent emission standards. The good news is that these headwinds are set to reverse course. Italian bond yields are well off their highs, as are oil prices (Chart I-12). German automobile production is recovering (Chart I-13). In addition, the European Commission expects the euro area fiscal thrust to reach 0.40% of GDP this year, up from 0.05% of GDP last year (Chart I-14). This should add about half a percentage point to growth. Finally, if our expectation that Chinese growth will bottom out by mid-year proves correct, European exports should benefit. Brexit still remains a risk, but a receding one. The political establishment on both sides of the British channel will not accept anything resembling a hard Brexit. As was the case with the EU treaty referendums involving Denmark and Ireland in the 1990s, the European political elites will insist on a “No fair! Let’s play again! Best two-out-of-three?” do-overs until they get the result they want. Theresa May’s efforts to cobble together a parliamentary majority that precludes a hard Brexit, along with the Labor Party’s increasing willingness to pursue a second vote, is consistent with our thesis. Fortunately for the “remain” side, public opinion is shifting in favor of staying in the EU (Chart I-15). Focusing on the minutiae of various timetables, rules, and regulations is largely a waste of time. If neither the political establishment nor the general public favor Brexit, it will not happen. Investment Conclusions Global growth is still slowing. Having rallied since the start of the year, global stocks will likely enter a “dead zone” for the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout. We think they will appear in the second quarter, setting the scene for a reacceleration in global growth in the second half of the year, and an accompanying rally in global risk assets. The dollar is a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart I-16). The greenback will strengthen a bit over the next few months, but should start to weaken in the summer as the global economy catches fire. We do not have a strong view on EM versus DM equities at the moment, but expect to shift EM to overweight once we see more confirmatory evidence that Chinese growth is stabilizing. In conjunction with our expected upgrade on EM assets, we will move European equities to overweight. Stronger global growth will benefit European multinational exporters, while brisker domestic growth should allow the market to price in a few more ECB rate hikes starting in 2020. The latter will lead to a somewhat steeper yield curve which, along with rising demand for credit, should boost financial sector earnings (Chart I-17). This will give European bank stocks a welcome boost. Japanese equities will also benefit from faster global growth, but domestic demand will suffer from the government’s ill-advised plan to raise the sales tax in October. As such, we do not anticipate upgrading Japanese stocks. We also expect the yen to come under some pressure as the BoJ is forced to maintain its ultra-accommodative monetary policy stance, while bond yields elsewhere move modestly higher. Peter Berezin    Chief Global Investment Strategist March 1, 2019 Next Report: March 28, 2019 II. Troubling Implications Of Global Demographic Trends Developed economies are challenged by two powerful and related demographic trends: declining growth in working-age populations, and a rapidly-aging population structure. Working-age populations are in absolute decline in Japan and much of Europe and growth is slowing sharply in the U.S. An offsetting acceleration in productivity growth is unlikely, implying a marked deceleration in economic growth potential. The combination of slower growth in the number of taxpayers and rising numbers of retirees is toxic for government finances. Future generations face sharply rising debt burdens and increased taxes to pay for entitlements. The correlation between aging and asset prices is inconclusive but common sense suggests it is more likely to be bearish than bullish. Population growth remains rapid throughout most of the developing world, China being a notable exception. It is especially strong in Africa, a region that has historically faced economic mismanagement and thus poor economic prospects for most of its inhabitants. Migration from the emerging to developed world is a logical solution to global demographic trends, but faces a backlash in many countries for both economic and cultural reasons. These tensions are likely to increase. Making accurate economic and market forecasts is daunting because there are so many moving parts and unanticipated events are inevitable. Quantitative models are destined to fail because of the unpredictability of human behavior and random shocks. Demographic forecasts are a lot easier, at least over the short-to-medium term. If you want to know how many 70-year olds there will be in 10 years’ time, then count how many 60-year olds there are today and adjust by the mortality rate for that age group. Demographic trends are very incremental from year to year and their impact is swamped by economic, political and financial events. Thus, it rarely makes sense to blame demographics for cyclical swings in the economy or markets. In some respects, demographics can be likened to glaciers. You will quickly get bored standing by a glacier to watch it move. But, over long time periods, glaciers cover enormous distances and can completely reshape the landscape. Similarly, over the timespan of one or more generations, demographics can have powerful effects on economies and societies. Some important demographic trends have been going on for long enough that their effects are visible. The most common concern about global demographics has tended to be overpopulation and pressure on resources and the environment. And this is hardly new. In 1798, Thomas Malthus published his “Essay on The Principles of Population” in which he argued that population growth would outstrip food supply, leading to a very miserable outcome. Of course, what he missed was the revolution in agricultural techniques that meant food supply kept up with population growth. In 1972, a group of experts calling themselves The Club of Rome published a report titled “The Limits to Growth” which argued that a rising world population would outstrip the supply of natural resources, putting a limit to economic growth. Again, that report underestimated the ability of technology to solve the problem of scarcity, although many still believe the essence of the report has yet to be proved wrong. Phenomena such as climate change and rising numbers of animal species facing extinction are seen as supporting the thesis that the world’s population is putting unsustainable demands on the planet. Rather than get into that debate, this report will focus on three particular big-picture problems associated with demographic trends: Declining working-age populations in most major industrialized economies during the next several decades. Population aging throughout the developed world. Continued rapid population growth in many of the world’s poorest and most troubled countries. According to the UN’s latest projections, the world’s population will increase from around 7.5 billion today to almost 10 billion by 2050.1 The population growth rate peaked in the 1970s and is expected to slow sharply over the next several decades (Chart II-1). Despite slower percentage growth rates, the population keeps going up steadily because one percent of the 1970 global population was about 3.7 million, while one percent of the current population is about 7.5 million. But here is an important point: virtually all future growth in the global population will come from the developing world (Chart II-2). The population of the developed world is expected to be broadly flat over the period to 2050, and this has some significant economic implications. Let’s first look at why population growth has stagnated in the developed world. Population growth is a function of three things: the birth rate, the death rate and net migration. Obviously, if there are more births than deaths then there will be a natural increase in the population and net migration will either add or subtract to that. Over time, there have been major changes in some of these drivers. In the developed world, a stable population requires that, on average, there are 2.1 children born for every woman. The fact that it is not exactly 2 accounts for infant mortality and because there are slightly more males than females born. The replacement-level fertility rate needs to be higher than 2.1 in the developing world because of higher infant mortality rates. After WWII, the fertility rate throughout most of the developed world was well above 2.1 as soldiers returned home and the baby boom generation was born. But, by the end of the 1970s, the rate had dropped below the replacement level in most countries and currently is a lowly 1.5 in Japan, Germany and Italy (Table II-1). It has stayed higher in the U.S. but even there it has dipped below the critical 2.1 level. This trend has reflected lot of factors including more widespread use of birth control and more women entering the labor force. In the developed world, the birth rate is expected to drop below the death rate in the next ten years (Chart II-3). That means there will be a natural decrease in the population. In the case of Japan, Germany, Italy and Portugal that change already occurred between 2005 and 2010. In the U.S., the UN expects birth rates to stay just above death rates in the period to 2050, but the gap narrows sharply. Births exceed deaths throughout most of the developing world meaning that populations continue to grow. Notable exceptions to this are Eastern Europe where populations are already in sharp decline and China, where deaths begin to exceed births in the 2030s. Although life expectancy is rising, death rates in the developed world will rise simply because the rapidly growing number of old people more than offsets the impact of longer lifespans. Of course, the population of a country can also be boosted by immigration, and that has been true for much of the developed world. In Canada and most of Europe, net migration already is the dominant source of overall population growth and it will become so in the U.S. in the coming decades, based on current trends (Chart II-4). This is the background to the first key issue addressed in this report: the declining trend in the growth of the working-age population in the developed world. Slowing Growth In Working-Age Populations An economy’s growth potential depends on only two things: the number of people working and their productivity. If the labor force grows at 1% a year and productivity also increases by 1%, then the economy’s trend growth rate is 2%. In the short-run, the economy may grow faster or slower than that, depending on issues like fiscal and monetary policy, oil prices etc. Over the long run, growth is constrained by people and productivity. The potential labor force is generally regarded to be the people aged 15 to 64. The growth trend in this age segment has slowed sharply in recent years in the major economies and is set to weaken further in the years ahead (Chart II-5). The problem is most severe in Japan and Europe where the working-age population is already declining. In the case of the U.S., growth in this age cohort slows from an average 1.5% a year in the 1960s and 1970s to a projected pace of less than 0.5% in the coming decades. While this generally is not a problem faced by the developing world, a notable exception is China, now reaping the consequences of its one-child policy. Its working-age population is set to decline steadily in the years ahead. Thus, it is inevitable that Chinese growth also will slow in the absence of an acceleration of productivity growth The slowing trend in the working-age population could be offset if we could get more 15-64 year olds to join the labor force, or get more older people to stay working. In the U.S., almost 85% of male 15-64 year olds were either employed or were wanting a job in the mid-1990s. This has since dropped to below 80% - a marked divergence from the trend in most other countries (Chart II-6). And the female participation rate in the U.S. also is below that of other countries. The reason for the decline in U.S. labor participation rates for prime-aged adults is unclear. Explanations include increased levels of people in full-time education, in prison, or claiming disability. A breakdown of male participation rates by age shows particularly sharp drops in the 15-19 and 20-24 age groups, though the key 20-54 age category also is far below earlier peaks (Chart II-7). The U.S. participation rate has recently picked up but it seems doubtful that it will return to earlier highs. Other solutions to the problem would be getting more people aged 65 and above to stay in the labor force, and/or faster growth in productivity. The former probably will require changes to the retirement age and we will return to that issue shortly. There always are hopes for faster productivity growth, but recent data have remained disappointing for most developed economies (Chart II-8). New technologies hold out some hope but this is a contentious topic. On a positive note, the shrinking growth of the working-age population may be easier to live with in a world of robotization and artificial intelligence where machines are expected to take over many jobs. That would support a more optimistic view of productivity but it remains to be seen how powerful the impact will be. Another important problem related to the slowing growth of the working-age population relates to fiscal burdens. In 1980, the level of government debt per taxpayer (ages 20-64) was around $58,000 in the U.S. in today’s money and this is on track for $104,000 by 2020 (Chart II-9). But this pales in comparison to Japan where it rises from $9,000 to $170,000 over the same period. Canada looks more favorable, rising from $23,000 in 1980 to $68,000 in 2020. These burdens will keep rising beyond 2020 until governments start running budget surpluses. Our children and grandchildren will bear the burden of this and won’t thank us for allowing the debt to build up in the first place. There will be a large transfer of privately-held assets from the baby boomers to the next generation, but the ownership of this wealth is heavily skewed. According to one study, the top 1% owned 40% of U.S. wealth in 2016, while the bottom 90% owned 20%.2 And it seems likely that this pool of wealth will erode over time, providing a smaller cushion to the following generation. This leads in to the next topic – aging populations. Aging Populations In The Developed World The inevitable result of the combination of increased life expectancy and declining birth rates has been a marked aging of populations throughout the developed world. Between 2000 and 2050, the developed world will see the number of those aged 65 and over more than double while the numbers in other age groups are projected to show little change (Chart II-10). As long as the growing numbers of those aged 65 and above are in decent health, then life is quite good. Fifty years ago in the U.S., poverty rates were very high for those of retirement age compared to the young (i.e. under 18). But that has changed as the baby boomer generation made sure that they voted for increased entitlement programs. Now poverty rates for the 65+ group are far below those of the young (Chart II-11). At the same time, real incomes for those 65 and older have significantly outperformed those of younger age groups. A major problem is that aging baby boomers are expensive because of the cost of pensions and medical care. As would be expected, health care costs rise dramatically with age. For those aged 44 and under, health care costs in the U.S. averaged around $2,000 per person in 2015. For those 65 and over, it was more than $11,000 per person. And per capita spending doubles between the ages of 70 and 90. So here we have the problem: a growing number of expensive older people supported by a shrinking number of taxpayers. This is illustrated by the ratio of the number of people between 20 and 64 divided by those 65 and older. In other words, the number of taxpayers supporting each retiree (Chart II-12). In 1980, there were five taxpayers for every retiree in the U.S., four in W. Europe and seven in Japan. These ratios have since dropped sharply, and in the next few decades will be down to 2.5 in the U.S., 1.8 in Europe and 1.3 in Japan. For each young Japanese taxpayer, it will be like having the cost of a retiree deducted from their paycheck. Throughout the developed world, the baby boomers’ children and grandchildren face a growing burden of entitlements. Some of the statistics related to Japan’s demographics are dramatic. In the first half of the 1980s there were more than twice as many births as deaths (Chart II-13). They become equal around ten years ago and in another ten years deaths are projected to exceed births by around three million a year. In 1990, the number of people aged four and under was more than double the number aged 80 and above. Now the situation is reversed with those aged 80 years and above more than double those four and under. That is why sales of adult diapers reportedly exceed those of baby diapers – very depressing!3 What’s the solution to aging populations? An obvious one is for people to retire later. When pension systems were set up, life expectancy at birth was below the age pensions were granted - typically around 65. In other words, not many people were expected to live long enough to get a government pension. And the lucky ones who did live long enough were not expected to be around to receive a pension for more than a few years. By 1950, those males who had reached the age of 65 were expected, on average, to live another 11 to 13 years in the major developed countries (Table II-2). This rose to 16-18 years by 2000 and is expected to reach 22-23 years by 2050. Governments have made a huge error in failing to raise the retirement age as life expectancy increased. Pension systems were never designed to allow people to receive government pensions for more than 20 years. Some countries have raised the retirement age for pensions, but progress on this front is painfully slow. Other solutions would be to raise pension contributions or to means-test benefits. Not surprisingly, governments are reluctant to take such unpopular actions. At some point, they will have no choice, but that awaits pressures from the financial markets. Currently, not many people aged over 65 remain in the workforce. The participation rate for men is less than 10% in Europe and less than 25% in the U.S. And it is a lot lower for women (Chart II-14). The rate in Japan is much higher reflecting the fact that it is at the leading edge of aging. Participation rates are moving higher in Europe and the U.S. and further increases are likely in the years ahead if Japan’s experience is anything to go by. Having people staying in the workforce for longer will help offset the decline in prime-age workers, but there is a downside. While it is a contentious topic, many studies point to a negative correlation between age and productivity after the age of 50. As we age, there is some decline in cognitive abilities and older people may be less willing or able to adapt to new technologies and working practices. These would only be partly offset by the benefits of experience that comes with age. Therefore, an aging workforce is not one where one would expect productivity growth to accelerate, other things being equal. An IMF study concluded that a 1% increase in the labor force share of the 55-64 age cohort in Europe could reduce the growth in total factor productivity by 0.2% a year over the next 20 years.4 Another study published by the NBER paper estimated that aging will reduce the U.S. economic growth rate by 1.2% a year this decade and 0.6% a year next decade.5 Other studies are less gloomy but it would be hard to argue that aging is actually good for productivity. Another aging-related issue is the implications for asset prices. It is generally believed that aging will be bad for asset prices as people move from their high-saving years to a period where they will be liquidating assets to supplement their incomes. This is supported by a loose correlation between the percentage of the labor force between 35 and 64 (the higher-saving years) and stock market capitalization as a percent of GDP (Chart II-15). However, other studies cast doubts on this relationship.6 One might think real estate is even more vulnerable than stocks to aging. However, in late 1988, two high-profile economists (Greg Mankiw and David Weil) published a report arguing that real house prices would fall substantially over the next two decades as the baby boom generation aged.7 That forecast was catastrophically wrong. Of course, that does not mean that the more dramatic aging occurring over the next couple of decades will not have a major negative impact on home prices. Numerous studies have been carried out on the relationship between demographics and asset prices and the conclusions are all over the place.8 Time and space constraints prevent a more in-depth discussion of this topic. Nonetheless, common sense would suggest that aging is more likely to be bearish than bullish for asset prices. Thus far, we have addressed two demographic challenges facing the developed world: slowing growth in the number of working-age people and a marked aging of the population. Much of the developing world has the opposite issue: continued rapid population growth and large numbers of young people. This is my third topic. Rapid Population Growth In The Developing World We already noted that nearly all future growth in global population will occur in the developing world, China being a notable exception. With birth rates remaining far above death rates, emerging countries will not have the aging problem of the developed world and this has some positives and negatives. On the positive side, a rapidly-growing young population creates the potential for strong economic growth – the opposite of the situation in advanced economies. But this assumes that the institutional and political framework is conducive to growth. Unfortunately, the history of many developing countries is that corrupt and incompetent governments prevent economies from ever reaching their potential. This means there will be a growing pool of young people likely facing a dim economic future. In some cases, these young people could be an excellent recruiting ground for extremist groups. It is unfortunate that there is particularly rapid population growth in some of the most troubled countries in the world. The Institute for Economics and Peace ranks countries by whether they are safe or dangerous.9 According to their ranking, the eight most dangerous countries in the world will see their population grow at a much faster pace than the developing world as a whole (Chart II-16). Some individual country comparisons are striking. The UN’s projections show that Nigeria’s population will exceed that of the U.S. by 2050, The Democratic Republic of Congo’s population will match that of Japan by 2030 and by 2050 will be 80% larger (Chart II-17A and B). Similarly, Afghanistan will overtake Italy in the 2040s. Most incredibly, Africa’s overall population surpassed that of the whole of Europe in the second half of the 1990s and is projected to be 3.5 times larger by 2050. That suggests that the numbers seeking to migrate from Africa to Europe will increase dramatically in the next couple of decades. Controlling these flows will become an increasing challenge for countries in Southern Europe. Migration is the logical solution to declining working-age populations in the developed world and expanding young populations in the developing world. However, there currently is a backlash against immigration in many developed countries. Anti-immigration political parties are gaining strength in many European countries and immigration was a major factor influencing the Brexit vote in the U.K. And it is a hot-button political issue in the U.S. Concerns about immigration are twofold: competition for employment and potential cultural change. Employment fears have coincided with a long period of severely depressed wages for low-skill workers in many developed economies and immigration is an easy target for blame. Meanwhile, the cultural challenge of absorbing large numbers of immigrants clearly has fueled increased nationalist sentiment in a number of countries. In the U.S., projections by the Bureau of the Census show that the non-Hispanic white population will fall below 50% of the total by 2045. That has implications for voting patterns and lies behind some of the concerns about high levels of immigration. There is no simple solution to this controversial issue and an in-depth discussion is beyond the scope of this article. Conclusions We have only touched on some aspects of demographic trends. It is a huge topic and has many other implications. For example, the political and cultural views of each generation are shaped by the environment they grow up in and this changes over time. This year, the number of millennials (those born from the early 1980s to the mid-1990s) in the U.S. is expected to surpass those of baby boomers and that will have important political and social implications. Again, that is beyond the scope of this report. The demographic trends we have discussed will pose serious challenges to policymakers. In the developed world, the baby boom generation has accumulated huge amounts of government debt, partly to fund generous entitlement programs and did not have enough children to ease the burdens on future generations. The young have good reason to feel frustrated by the actions of their elders (see cartoon). In the developing world, the challenge will be to provide economic opportunities for a growing pool of young people. The biggest problems will be in Africa, a continent where economic success stories have been few and far between in the past. Failure to deal with this will have troubling implications for geopolitical stability. Martin H. Barnes Senior Vice President Economic Advisor III. Indicators And Reference Charts Our tactical equity upgrade is beginning to pay off, and an increasing proportion of our proprietary indicators is confirming that stocks have more upside over the next few quarters. Our Willingness-to-Pay (WTP) indicator for the U.S. has stopped falling. This pattern is also evident in both Europe and Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. After clearly pulling funds out of the equity markets, investors are beginning to tip their toes back in. Our Revealed Preference Indicator (RPI) has clearly shifted back into stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. According to BCA’s composite valuation indicator, the U.S. stock market remains overvalued from a long-term perspective, despite the dip in multiples since last fall. It is a composite of 11 different valuation measures. Moreover, our Monetary Indicator has shifted out of negative territory for stocks, and is now decisively in stimulative territory. The Fed pause, along with some dovish-sounding commentaries have improved the monetary backdrop by removing expected rate hikes from the money market curve. Our Composite Technical indicator for stocks broke down in December, providing a clear ‘sell’ signal, and has not yet delivered a ‘buy’. However, if the recent improvement in this indicator can continue, the S&P 500 will likely be able to punch above the 2800 level. The 10-year Treasury yield is in the neutral range according to our valuation model. Bonds are not overbought, but they have now fully worked out their previously deeply-oversold conditions. The Adrian, Crump & Moench formulation of the 10-year term premium remains close to its 2016 nadir, suggesting that yields are unsustainably low. Our bond-bearish bias is consistent with the view that the Fed rate hike cycle is not over. The U.S. dollar is still very expensive on a PPP basis. Our Composite Technical Indicator is not as overbought as it once was, but it is far from having reached oversold levels either. This combination suggests that the greenback could experience further downside over the coming month. It remains to be seen if this wave of depreciation will mark the beginning of the cyclical bear market required to correct the dollar’s overvaluation. EQUITIES: FIXED INCOME:     CURRENCIES:   COMMODITIES:   ECONOMY: Mark McClellan Senior Vice President The Bank Credit Analyst   Footnotes 1       Most of the data referred to in this report comes from the medium variant projections from the United Nation’s World Population Prospects report, 2017 revision. There is an excellent online database tool that allows users to access numerous demographic series for every country and region in the world. This can be found at https://population.un.org/wpp/DataQuery/ 2       Edward N. Wolff, Household Wealth Trends in the United States, 1962 to 2016. NBER Working Paper 24085, November 2017. Available at: https://www.nber.org/papers/w24085. 3       This is not a joke: https://www.businessinsider.com/signs-japan-demographic-time-bomb-2017-3 4       The Impact of Workforce Aging on European Productivity. IMF Working Paper, December 2016. Available at: https://www.imf.org/en/Publications/WP/Issues/2016/12/31/The-Impact-of-Workforce-Aging-on-European-Productivity-44450 5       The Effect of Population Aging on Economic Growth, the Labor Force and Productivity. NBER Working Paper 22452, July 2016. Available at https://www.nber.org/papers/w22452.pdf 6              For example, see “Will Grandpa Sink The Stock Market?”, The Bank Credit Analyst, September 2014. 7       The Baby Boom, The Bay Bust, and the Housing Market. NBER Working Paper 2794. Available at: https://www.nber.org/papers/w2794 8       For those interested in this topic, we recommend the following paper: Demographics and Asset Markets: A Survey of the Literature. Available at: https://pdfs.semanticscholar.org/912a/5d6d196c3405e37b3a50d797cbf65a27ba44.pdf 9       Global Peace Index, 2018. Available at: http://visionofhumanity.org/app/uploads/2018/06/Global-Peace-Index-2018-2.pdf. According to this index, the eight least-safe countries are (starting with the most dangerous): Syria, Afghanistan, South Sudan, Iraq, Somalia, Yemen, Libya, and Democratic Republic of the Congo. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights A no-deal Brexit which did not cause pain pour encourager les autres would be the much graver existential threat for the EU. A U.K. parliamentary vote to extend Article 50 by a few months would not be a game changer in itself, because it just delays the day of judgement. The real denouement will only happen when a workable route to a benign Brexit option commands a majority in the U.K. parliament. This is the point at which U.K. exposed risk-assets would outperform sustainably. Investors should then buy: the pound, the FTSE250, FTSE Small Cap, and U.K. homebuilders. Feature Chart of the WeekU.K. Homebuilders Is The Best Equity Sector To Play Brexit The Article 50 process that governs Brexit is fast approaching its two-year time limit, and the question naturally arises as to what will happen when the clock strikes midnight on March 29.1  To answer this question, it is worth stepping back to ask something even more fundamental: what was the purpose of the two-year time limit in the first place? The EU Must Protect The Integrity Of The Union The two-year time limit in Article 50 was designed to disadvantage the exiting country relative to the EU, and this disadvantage has now become abundantly clear. After the two years have run down, a no-deal or ‘cliff edge’ exit would be bad for the EU27, but it would be far worse for the U.K. This balance of power has put the EU27 very much in the driving seat of the Brexit process, and there is no reason to presume that the EU27 will do anything other than prioritise and protect its own interests. For the EU27, the priority right now is to protect the unity and integrity of the Union in the face of a growing existential threat from populists and nationalists. Unfortunately, much of this has been overlooked in the Brexiteer rhetoric, with arguments like "they need to sell us their BMWs and Prosecco". Clearly, frictionless and barrier-less trade is in the economic interests of both parties, but the economic reality is that less than a tenth of EU27 exports go to the U.K. while something approaching half of U.K. exports go to the EU27 (Chart I-2 and Chart I-3). Chart I-2Less Than A Tenth Of EU27 Exports Go To The U.K. ... Chart I-3...While Almost Half Of U.K. Exports Go To the EU27 Brexit is essentially a huge economic gamble in the name of an overarching political aim to ‘take back control’ (Chart I-4). Remember that the case for Brexit largely hinged on the desire to regain political sovereignty: specifically, controlling migration and ending the supremacy of the European Court of Justice. That’s fine, we have no qualms about that. But if the case for Brexit was largely political, it’s a bit rich to presume that the EU27 will not also prioritise its own overarching political aims – even if these political aims come at the cost of a short-term setback to the European economy. Chart I-4U.K. House Prices Have Stagnated Since The Brexit Negotiations Started Brexit Is The Litmus Test For Optimality Of The EU A catastrophic no-deal Brexit would undoubtedly hurt the EU27, and be particularly painful for the member states most exposed to U.K. trade, notably Ireland and the Netherlands. But here’s the paradox: a no-deal Brexit which did not cause pain pour encourager les autres would be the much graver existential threat for the EU. If membership of the EU and its institutions is supposedly an optimal economic and political structure for European states, then Brexit is the litmus test for the sub-optimality of exiting, and especially the heavy cost of exiting abruptly. If, after the two-year notice of Article 50, the U.K. abruptly left the EU with negligible disruption and then quickly thrived outside the EU, it would galvanize the European nationalists and populists to emulate a newly confident and resurgent U.K.’s quick and painless divorce. As this could be the death knell of the European project, the paradox is highlighted in our mischievous title: why a catastrophic no-deal might be good… for the EU. Brexit can take three ultimate shapes: The U.K. revokes its intention to withdraw the EU and remains a full member of the Union. A long transition to a new and negotiated trading relationship between the U.K. and the EU27. A sharp cliff-edge in which the U.K. abruptly becomes a third country to the EU27. The U.K. population now clearly favours option 1 – remain – over the two alternatives (Chart I-5). Meanwhile, the U.K. parliament has expressed its opposition, albeit not yet legally binding opposition, to option 3 – the no-deal Brexit. As for the EU27, the best outcome is for the U.K. to revoke its intention to withdraw and thrive within the club; the next best outcome is a long transition to Brexit, during which and after which the U.K. economy underperforms its European peers to illustrate the sub-optimality of exiting. But if Brexit is a cliff-edge, it has to be demonstrably painful. Hence, the EU27 will want to put off the day it has to confront this paradox if there is any chance of avoiding it. Article 50 does allow for this delay. The specific wording of paragraph 3 states: The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification referred to in paragraph 2, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period. But a close reading suggests that if there is still a real possibility of finalising a withdrawal agreement, or if withdrawal is an outcome that the State no longer desires, then this would not represent ‘failing’. Meaning that the period of negotiation of a withdrawal agreement could be extended beyond March 29, or indeed Article 50 could be entirely revoked. A Short Delay Is Not A Game Changer, But A Second Referendum Would Be Looking at the desired outcomes of the U.K. population, the U.K. parliament, and the EU27, Brexit should rationally end up as benign options 1 or 2. The trouble is that rational outcomes can be thwarted if there is no mechanism to implement them. Although the U.K. parliament has expressed its desire to avoid a no-deal, it has not yet coalesced a majority around how exactly to avoid the cliff-edge outcome. A parliamentary vote to extend Article 50 by a few months would not be a game changer in itself because it just delays the day of judgement, though a longer extension would be more significant. But if the extension facilitated a second referendum or a general election, then that would be a game changer – as there would be the potential for the U.K. population to overturn the decision to leave.    It follows that the real denouement will only happen when a workable route to either of the benign Brexit options 1 or 2 above commands a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – permanent customs union, Common Market 2.0, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a positive course of action that eliminates no-deal rather than just delays it. This would be the point at which the BoE is finally liberated from its emergency policy (Chart I-6 and Chart I-7), pushing up U.K. gilt yields relative to other government bond yields (Chart I-8), and allowing a sustained rally in the pound (Chart I-9). Chart I-6Brexit Has Subdued The BoE... Chart I-7...Despite A Tight U.K. Labour Market Chart I-8Were It Not For Brexit, U.K. Interest Rates Would Be 1 Percent Higher... Chart I-9…And The Pound Would Be At $1.50 In this event, U.K. exposed risk-assets would also outperform. Note that the FTSE100 is not one of these investments. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index (Chart I-10). Instead, investors should focus on: the FTSE250 (Chart I-11) and the FTSE Small Cap, but the best play is the U.K. homebuilders (Chart of the Week). Chart I-10When The Pound Rallies, The FTSE100 Underperforms... Chart I-11...So Prefer The FTSE250 Fractal Trading System* We are pleased to report that long Italy’s MIB versus Eurostoxx600 reached the end of its 3-month holding period very comfortably in profit which is now crystallised. This week, we note that the sharp underperformance of aluminium versus tin is at the limit of tight liquidity which has previously signalled a trend-reversal. Hence, the recommended trade is long aluminium versus tin. Set a profit target of 6.5 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Midnight British Summer Time Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations