Geopolitics

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Kumbaya Kumbaya Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Kumbaya Kumbaya Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Successive Rounds Of Tariffs Have Started To Add Up Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Kumbaya Kumbaya Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound Substantial Upside In The Pound Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Growth Slowdown Has Been More Pronounced In The Soft Data Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump Manufacturing Output Rebounds Amid The ISM Slump Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Chinese Credit Should Support The Recovery In Global Growth Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Kumbaya Kumbaya Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. The Equity Risk Premium Is Quite High, Especially Outside The U.S. The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Kumbaya Kumbaya Strategic Recommendations Closed Trades

Highlights There is a tentative decline in geopolitical risk: An orderly Brexit or no Brexit is the likely final outcome and the U.S.-China talks are coming together. The outstanding geopolitical risks still warrant caution on global equities in the near term. Internal and external instability in Saudi Arabia, any American persistence with maximum pressure sanctions on Iran, and domestic instability in Iraq pose a risk to global oil supply. Go long spot crude oil and GBP/JPY. Feature Chart 1A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk Our views on Brexit and the U.S.-China trade talks are coming together, resulting in a tentative decline in geopolitical risk (Chart 1). The British parliament still needs to ratify Boris Johnson’s exit agreement, painstakingly negotiated with the EU in a surprise summit this week. He may not have the votes. If he fails then he will have a basis to seek an extension to the Brexit deadline on October 31. But it is clear that the EU is willing to allow compromises to prevent a no-deal exit shock from exacerbating the slowdown in the European economy. An orderly Brexit is the final outcome (or no Brexit at all if an election and new referendum should say so). We are removing the $1.30 target on our long GBP/USD call in light of these developments and going long GBP/JPY. Similarly, while uncertainty lingers over U.S.-China relations, it is clear that President Trump is sensitive to the impact of the manufacturing recession and the risk of an overall recession on his reelection prospects. He is therefore pursuing a ceasefire and delaying tariffs. China is minimally reciprocating to forestall a collapse in relations. The December 15 tariff hike will be delayed and, if a ceasefire fails to improve the economic outlook, we expect Trump to engage in some tariff rollback on the pretext that talks are “making progress.” However, we do not expect a bilateral trade agreement or total tariff rollback. And other factors (like political risks in Greater China) could still derail the process. The outstanding geopolitical risks still warrant caution on global equities in the near term. These risks include a collapse in the U.S.-China talks (e.g. due to Hong Kong, Taiwan, or the tech race), and the ascent of Elizabeth Warren as the front runner in the Democratic Party’s early primary election. There is also the risk of another oil price shock emanating from the Middle East, which we discuss in this report. The Aftermath Of Abqaiq It has been a geopolitically eventful summer in the Middle East (Diagram 1). While there were plenty of warning shots, the September 14 drone and missile strikes on Saudi Aramco infrastructure was the big bang – wiping out 5.7 mm b/d of crude oil supplies overnight (Chart 2). The attacks were significant not only in terms of their impact on global oil markets, but also because they exposed the U.S.’s and Saudi Arabia’s reluctance to engage in a full-scale military confrontation with Iran. It is too early to call peak tensions in the Persian Gulf. Diagram 1Timeline: Summer Fireworks In The Persian Gulf Around The Middle East Around The Middle East Chart 2Closing Hormuz Would Be The Biggest Oil Shock Ever Around The Middle East Around The Middle East It is too early to call peak tensions in the Persian Gulf. The October 11 strike on an Iranian-owned oil tanker in the Red Sea and the reported U.S. cyber-attacks against Iranian news outlets may well mark the “limited retaliation” that we expected. Nevertheless, last month’s events uncovered vulnerabilities that suggest that even if the U.S. and its Gulf allies back off, geopolitical risk will remain elevated. Chart 3Saudis Are Profligate Defense Spenders Around The Middle East Around The Middle East The most obvious outcome of the September 14 attack is the realization of just how vulnerable Saudi Arabia is to attacks by its regional enemies. Despite being the third most profligate defense spender in the world – and the first relative to GDP (Chart 3) – Saudi Arabia was unable to protect its critical infrastructure. For that, Crown Prince Mohamed bin Salman (MBS) will surely face domestic pressure. After five years, Saudi Arabia has little to show from its war in Yemen, other than a humanitarian crisis that has hurt its international standing. Instead, the operation has been a burden on the kingdom’s finances and a nuisance to security in the southwestern provinces of Najran, Jizan and Asir, where the Iran-allied Houthis have conducted regular attacks on oil infrastructure and airports. Some domestic disquiet will be defused if the Yemen war is downgraded or resolved. Saudi Arabia recently accepted the olive branch extended by the Houthis and is reportedly in talks to deescalate. But this will not fully eliminate domestic uncertainty. After all, MBS’s other initiatives – in Syria, in Iraq, in lobbying the U.S. – are also in jeopardy. The conspiracy theory surrounding the September 29 murder of General Abdulaziz al-Faghem, King Salman’s longstanding personal bodyguard, is case in point. Rumor has it that the king was enraged upon hearing of the Houthi movement’s September 28 capture of three Saudi military brigades, and decided to revoke the Crown Prince’s title, instead appointing the youngest Sudairi brother, Prince Ahmed bin Abdulaziz, in his place.1 The ploy was allegedly uncovered, resulting in General al-Faghem’s murder.2 This is entirely speculation and we find the idea of MBS’s removal to be highly doubtful. The King’s and Crown Prince’s joint appearance during President Vladimir Putin’s visit to the kingdom earlier this week should dispel speculation about a brewing palace coup. Nevertheless, the murder itself is extremely concerning and reinforces independent reasons for concerns about internal stability. Chart 4Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability The pursuit of the Saudi reform agenda, “Vision 2030,” is premised first and foremost on the consolidation of power in the hands of MBS and his faction. The appointment of King Salman’s son, Prince Abdulaziz, as energy minister was motivated by a desire to expedite the initial public offering of state oil giant Saudi Aramco, which could begin as early as November. This was preceded by the appointment of Yasir Al-Rumayyan, head of the sovereign wealth fund and a close ally of MBS, as chairman of Aramco. Moreover, wealthy Saudis – some of whom were detained at the Ritz Carlton in November 2017 – are reportedly being strong-armed into buying stakes in the pending IPO. While weaning Saudi Arabia’s economy off of crude oil is the best course of action for long-term stability (Chart 4), the transition will threaten domestic stability. Meanwhile the conflict with Iran is far from settled. Bottom Line: The September 14 drone strikes on key Saudi oil infrastructure revealed both Saudi Arabia’s and the U.S.’s unwillingness to engage in military action against and a full confrontation with Iran. This will raise concerns regarding the kingdom’s ability to defend itself. Moreover, Saudi Arabia remains vulnerable to domestic pressure as MBS strives to maintain his consolidation of power in recent years and pursues Vision 2030. Internal or external instability in Saudi Arabia poses a risk to global oil supply. Iran’s Resistance Economy Can Handle Trump’s Maximum Pressure Chart 5Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite On the other side of the Persian Gulf, the Iranians are displaying a higher pain threshold than their enemies. The economy is suffering under the U.S.’s crippling sanctions, with exports at the lowest level since 2003 (Chart 5). The IMF expects Iran’s economy to contract by 9.5% this year, with annual inflation forecast at 35.7%. Oil exports, the lifeblood of its economy, are down 89% YoY. Nevertheless, Iran is well-versed in the game of chicken, it is methodically displaying its ability to create havoc across the region, and it has not waivered in its stance that President Trump must ease sanctions and rejoin the 2015 nuclear deal if it is to engage in bilateral talks. All the while, Iran continues to reduce its nuclear commitments. On September 5, Rouhani indicated plans to completely abandon research and development commitments under the Joint Comprehensive Plan of Action (JCPOA) and to begin working on more advanced uranium enrichment centrifuges which was capped at 3.7% under the JCPOA (Table 1). We also expect Iran to follow-through on its threat of withdrawing from the Nuclear Non-Proliferation Treaty (NPT) if Trump maintains sanctions. Table 1Iran Is Walking Away From 2015 Nuclear Deal Around The Middle East Around The Middle East The same resolve cannot be shown on the part of the United States or Saudi Arabia. Chart 6Americans Do Not Support War With Iran Around The Middle East Around The Middle East President Trump is constrained by the risk of an Iran-induced oil price shock ahead of the 2020 election. He is therefore eager to deescalate tensions with Iran. He is abandoning the field in Syria (on which more below), opting to add a symbolic 1,800 troops into Saudi Arabia for deterrent effect instead. This defensive posture is being undertaken within the context of American public opinion, which opposes war with Iran or additional military adventures in the Middle East (Chart 6). This signifies the U.S.’s strategic deleveraging from the Middle East in order to shift its focus to Asia Pacific, where America has a greater priority in managing the rise of China. At the same time, negotiations between the Saudis and Yemeni Houthis suggest a lack of Saudi appetite for all-out conflict with Iran, clearing the way for a diplomatic solution. As Rouhani stated “ending the war in Yemen will pave the ground for de-escalation in the region,” specifically between Saudi Arabia and Iran. The Saudis have amply signaled in the wake of the Abqaiq attack that they wish to avoid a direct confrontation, particularly given the Trump administration’s apparent unwillingness (under electoral constraint) to continue providing a “blank check” for MBS to conduct an aggressive foreign policy. Already the United Arab Emirates – a key player in the Saudi-led coalition against Yemen – has distanced itself from Riyadh and sought to ease tensions with Iran. It recently reduced its commitment to the Yemen war and engaged in high-level meetings with Iran. The UAE’s national security adviser, Tahnoun bin Zayed, visited Tehran on a secret mission, the latest in a series of backchannel efforts to mediate between Saudi Arabia and Iran. Other reported efforts at diplomacy include visits by Iraqi and Pakistani officials. The remaining uncertainty is whether Trump will quietly ease sanctions on Iran, and whether Iran will quit while it is ahead. If Trump maintains maximum pressure, Iran may need to stage further attacks and oil disruptions to threaten Trump’s economy and encourage sanction relief. Otherwise, Iran, smelling American and Saudi fear, could overstep its bounds and commit a provocation that requires a larger American response, thus re-escalating tensions. While Trump’s economic and electoral constraint suggests that he will ease sanctions underhandedly, Iran’s risk appetite is apparently very high: Abqaiq could have gone terribly wrong. It also has an opportunity to flex its muscles and demonstrate American inconstancy to the region. This could lead to miscalculation and a more significant oil price shock than already seen. Bottom Line: Iran has remained steadfast in its position while the United States, Saudi Arabia, and their allies appear to be capitulating. They have more to lose than gain from all-out conflict. But Iran’s decision-making is opaque and any American persistence with maximum pressure sanctions will motivate additional provocations, escalation, and oil supply disruption. Making Russia Great Again? Recent events in Turkey and Syria do not come as a surprise. We have long highlighted a deeper Turkish intervention into Syria as a regional “black swan” event. In August we warned clients that the Trump-Erdogan personal relationship would not save Turkey from impending U.S. sanctions. In September we warned that Turkish geopolitical risk premia had collapsed, as measured by our market-based GeoRisk indicator, and that this collapse was certain to reverse in a major way, sending the lira falling. As we go to press the Turks have declared a ceasefire to avoid sanctions but nothing is certain. Putin has pounced on the opportunity to capitalize on the U.S. retreat. If Turkey is the loser, who is the winner? First, Trump, who benefits from fulfilling a campaign pledge to reduce U.S. involvement in foreign wars – a stance that will ultimately be rewarded (or at least not punished) by a war-weary public. Second, Iran and Russia, Syria’s major allies, who have invested greatly in maintaining the regime of Bashar al-Assad throughout the civil war and now face American withdrawal and heightened U.S. tensions with its allies and partners in the region as a result. Iran benefits through the ability to increase its strategic arc, the so-called “Shia Crescent,” to the Mediterranean Sea. Russia benefits through solidifying its reclaimed status as a major player in the Middle East – an indication of global multipolarity. President Vladimir Putin has pounced on the opportunity to capitalize on the U.S. retreat with official visits to both Saudi Arabia and the UAE this week. He made promises of both stronger economic ties and the ability to broker regional power. On the economic front, the Russian Direct Investment Fund (RDIF) selected Saudi Arabia as the venue for its first foreign office, signaling its interest in the region. It has already approved 25 joint projects with investment valued at more than $2.5 billion. There are also talks of RDIF-Aramco projects in the oil services sector worth over $1 billion and oil and gas conversion projects worth more than $2 billion. Moreover, RDIF signed multiple deals worth $1.4 billion with UAE partners. Chart 7Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Most importantly, the Saudis and Russians share the same objective of supporting global oil prices and have been jointly managing OPEC 2.0 supply since 2017 (Chart 7). Russia’s approach to the region focuses on enhancing its all-around strategic influence. Chart 8Erdogan Is Playing Into Turkish Concerns About Syrian Refugees Around The Middle East Around The Middle East Although Russia’s allies include Iran and Syria – Saudi Arabia’s rivals – it has presented itself as a pragmatic partner to other powers, including Turkey and even the Saudis and Gulf states. As such, the Kremlin has leverage on both sides of the regional divide, giving it the potential to serve as a power broker. However, any Saudi purchase of the Russian S-400 defense system, long under negotiation, would unsettle the United States. Turkey is threatened with American sanctions for its purchase of the same system.3 The U.S. may be willing to tolerate some increased Russian influence in the Middle East, but a defense agreement may be its red line. The Trump administration still wields the stick of economic sanctions. Growing Russian influence extends beyond the Gulf states. The U.S.’s withdrawal from northeast Syria last week and the Turkish invasion is a gift to the Russians. They are now the only major power from outside the Middle East engaged in Syria. They have embraced this position, positioning themselves as peace brokers between the Syrian regime, with whom they are allied, and Turkey, as well as the Turkish arch-enemy, the Kurds, who now lack American support and must turn to Syria and Russia for some kind of arrangement to protect themselves. Russia has therefore cemented its return as a strategic player in the region, after its initial intervention in Syria in 2015. Turkey’s incursion into Syria is an attempt by President Erdogan to confront the battle-hardened Syrian Kurds and prevent a Kurdish-controlled continuous border with Syria, and to distract from his weakened domestic position. He is striving to garner support by playing to broad Turkish concerns about Syrian refugees in Turkey (Chart 8). The intervention will seek to create a space for refugees to be placed on the Syrian side of the border. However given that there is little domestic popular support for a military intervention, he runs the risk of further alienating voters, who are already losing patience with his ruling Justice and Development Party (AKP). So far, the incursion has the official support of all Turkey’s political parties except the Kurdish Peoples’ Democratic Party (HDP). However this will change as the intervention entails western economic sanctions, a drawn-out military conflict, and limited concrete benefits other than the removal of refugees. Chart 9Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit The already vulnerable economy is likely to take a hit (Chart 9). Markets have reacted to the penalties imposed by the U.S. so far with a sigh of relief as they are not as damaging as they could have been – i.e. Turkish banks were spared.4 However, this is just the opening salvo and more sanctions are on the way – Congress is moving to impose sanctions of its own, which Trump is unlikely to veto. Moreover, the European Union is following suit and imposing sanctions of its own, including on military equipment. Volkswagen already announced it is postponing a final decision on whether to build a $1.1 billion plant in Turkey. This comes at a time of already existing sensitivities with the EU over Turkish oil and gas drilling activities in waters off Cyprus. EU foreign ministers are responding by drawing up a list of economic sanctions. These economic risks will likely hold back the central bank’s rate cutting cycle as the lira and financial assets will take a hit. Bottom Line: The U.S. pivot away from the Middle East is a boon for Moscow, which is pursuing increased cooperation in the Gulf and gaining influence in Syria. Russia is marketing itself as a strategic player and effective power broker. Erdogan’s incursion in Syria, while motivated by domestic weakness, will backfire on the Turkish economy. Maintain a cautious stance on Turkish currency and risk assets. Iraq Is The Fulcrum Iraq’s geographic position, wedged between Saudi Arabia and Iran, renders it the epicenter of the regional power struggle. In the wake of the Trump administration’s maximum pressure campaign on Iran we have frequently highlighted that a dramatic means of Iranian pushback, short of closing shipping in the Strait of Hormuz, is fomenting unrest in an already unstable Iraq. This would be a threat to U.S. strategy as well as to global oil supplies. Iraq is the epicenter of the regional power struggle. In this context, Iraq’s revered Shia cleric Muqtada al-Sadr’s visit to Iran on September 10, just four days ahead of the September Saudi Aramco attack, raises eyebrows. Sadr is the key player in Iraq today and over the past two years he had staked out a position of national independence for Iraq, eschewing overreliance on Iran. A rapprochement between Sadr and Iran is a negative domestic development for Iraq, which has recently been making strides to reduce Iran’s political and military grip. It would undermine Iraqi stability by increasing divisions over ideology, sect, economic patronage, and national security. There is speculation that Sadr’s trip was intended to discuss Prime Minister Adel Abdul Mahdi, who is perceived as weak and incapable of managing the various powers on Iraq’s political scene. The violent protests rocking Iraq since early September support this assessment. Protestors are motivated by discontent over unemployment, poor services, and government corruption, which are perceived to have mostly deteriorated since the start of Abdul Mahdi’s term (Chart 10). While Abdul Mahdi has announced some reforms in response to the popular discontent, including a cabinet reshuffle and promises of handouts for the poor, they have done little to quell the protests. The popular demands are only one of the existential threats facing the government. The second and potentially more serious risk is the security threat. Iraq has been failing at its attempts to formally integrate the Popular Mobilization Units (PMU) – Iran-backed paramilitary groups that were instrumental in ISIS’s defeat – into the national security forces. This is essential in order to prevent Iran from maintaining direct control of security forces within Iraq. A majority of the public agrees that the PMU should not play a role in politics (Chart 11), reflecting the underlying trend demanding Iraqi autonomy from Iran. Chart 10Rising Discontent In Iraq Around The Middle East Around The Middle East Chart 11Little Support For A Political Role For The PMU Around The Middle East Around The Middle East Given that the PMU is in effect an umbrella term for ~50 predominantly Shia paramilitary groups, internal divisions exist within the forces which compete for power, legitimacy, and resources. Recently, it has been purging group leaders perceived as a threat to the overall forces and the senior leadership which maintain strong links to Iran. Chart 12Iraq Is Divided Across Political Affiliation Around The Middle East Around The Middle East This internal struggle also reflects the intra-Shia struggle for power among Iraq’s main political parties. On the one side there is the conservative, pro-Khamenei bloc led by former Prime Minister Nouri al-Maliki and PMU commander Hadi al-Ameri, and on the other is the reformist, nationalist leader Muqtada al-Sadr’s joined by Ammar al-Hakim. Given that most Iraqis view their country as a divided nation across political affiliation, this is a risk to domestic stability (Chart 12). Thus even if the wider risk of regional tensions abates and reduces the threat of sabotage to oil infrastructure and transportation, the current domestic situation in Iraq remains uneasy. But given that we do not see the regional tensions abating yet – due to either American maximum pressure or Iranian hubris – this dynamic translates into an active threat to oil supplies, with 3.4 mm b/d of exports concentrated in the southern city of Basra. Bottom Line: Heightened domestic instability in Iraq poses a non-negligible threat to oil supplies. This risk is compounded by Iraq’s location as a geographic buffer between regional rivals Iran and Saudi Arabia, and Iran’s interest in fomenting unrest to pressure the U.S. into relaxing sanctions. Investment Conclusions The common thread across the Middle East is a persistent threat to global oil supply in the wake of the extraordinary Abqaiq attack. First, it cannot be stated with confidence that Iran will refrain from causing additional oil disruptions, as it is convinced that President Trump’s appetite for conflict is small (and Trump is indeed constrained by fear of an oil shock). President Rouhani has an interest in removing Trump from power, which an oil shock might achieve, and the Supreme Leader may even be willing to risk a conflict with the United States as a means of increasing support for the regime and infusing a new generation with revolutionary spirit. Iran loses in a total war, but Tehran is convinced that the U.S. does not have the will to engage in total war. Second, Russia’s interest in the region is not in generating a durable peace but in filling the vacuum left by the United States and making itself a power broker. Any instability simply increases oil prices which is positive for Russia. Third, Iraq’s instability is both domestically and internationally driven. It is nearly impossible to differentiate between the two. Iranian hubris could manifest in sabotage in Iraq. Or Iraq could destabilize under the regional pressures with minimal Iranian encouragement. Either way the world’s current below-average spare oil production capacity could be hit sooner than expected if shortages result. Go long spot crude oil. On equities, with a U.S.-China ceasefire in the works, and little chance of a no-deal Brexit, we see our cyclically positive outlook reinforced, though we maintain near-term caution due to U.S. domestic politics. In terms of equity focus, we are overweight European equities in developed markets and Southeast Asian equities in emerging markets.   Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Sudairi branch of the al-Saud family is made up of the seven sons of the late King Abdulaziz and Hussa al-Sudairi of the powerful Najd tribe. 2 Please see TRT World “Killing of Saudi King’s Personal Bodyguard Triggers Speculation,” October 2, 2019, available at https://www.trtworld.com. 3 In the wake of the attack on Saudi Aramco oil facilities, President Putin trolled the U.S. by recommending that Saudi Arabia follow the footsteps of Iran and Turkey in purchasing Russia’s S-300 or S-400 air defense systems. 4 The U.S. penalties include sanctions against current and former officials of the Turkish government, a hike in tariffs on imports of Turkish steel back up to 50 percent, and the halt in negotiations on a $100 billion trade deal.

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 NZD VS. JPY NZD VS. JPY 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. 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, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese automobile industry outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima China Strategist Feature Chart 1Chinese Economy Likely To Bottom In Q1 Chinese Economy Likely To Bottom In Q1 Chinese Economy Likely To Bottom In Q1 President Trump announced last Friday the first phase of a potential trade agreement with China. For now, the most concrete aspect of the announcement has been the deferral of an increase in tariffs that had been scheduled to occur this week, in exchange for agriculture purchase commitments from China. Market participants initially reacted with caution to the news, given the U.S. administration’s about-face in early-May and given signs from Beijing that China “needs time” to finalize a deal. However, Chinese policymakers have subsequently played up the progress made during the negotiations, and characterized both sides as being on “the same page”. We noted in last week’s report that China’s economy was likely to stabilize in Q1 of next year (Chart 1), but that a further shock to China’s external sector and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown.1 This, to us, justified a tactically bearish stance towards Chinese stocks, despite our positive cyclical bias. Indeed, following our tactical underweight call initiated on July 24,2 relative to global stocks, Chinese investable stocks dropped nearly 3% in the months of August and September in reaction to intensified trade tension. Chart 2Chinese Stocks Have Been Underperforming Since Late April Chinese Stocks Have Been Underperforming Since Late April Chinese Stocks Have Been Underperforming Since Late April While it is not yet clear how substantive the final deal between the U.S. and China will be, it is our judgment that the odds of a further escalation in the trade war have legitimately fallen over the past week. Both sides of the negotiating table have strong incentives to reach a deal (particularly the U.S.), and both U.S. and Chinese policymakers may finally be acting in a way that is consistent with each side’s respective constraints. As such, we no longer feel that a tactical underweight stance is warranted, and we recommend that clients maintain a neutral stance towards Chinese stocks over the near term. The potential for the talks to collapse once again is keeping us from recommending an outright overweight tactical stance, as well as the small but still non-trivial chance that the final deal is not meaningful enough to help revive economic activity. Cyclically, a substantive trade deal would be bullish for Chinese stocks, as the relative performance of both the investable and domestic markets are meaningfully below their late-April highs (Chart 2). The stimulus that policymakers have already provided should be enough to stabilize Chinese domestic demand, and a trade deal should help reinforce a stabilization in sentiment and activity over the coming year. However, one risk to our cyclical positioning is that the removal of uncertainty for China’s exporters strengthens the will of Chinese policymakers to curb “excess” credit growth. For now, this remains “a story for another day”, as investors will almost certainly bid up Chinese stocks (particularly the investable market) in reaction to a deal. But the behavior of China’s credit impulse following the surge in Q1 of this year underscores that policymakers are very serious about preventing another significant rise in the macro leverage ratio. This could lead to a less optimistic outlook over the coming 6-12 months than we originally expected when we recommended upgrading Chinese stocks earlier this year, and is a risk that we will be continually monitoring over the coming months. Stay tuned!   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1      Please see China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing”, dated October 9, 2019, available at cis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact China's Property Bubble Intact China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation China's Constraint Is Debt-Deflation China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Trump Faces Pressure To Stage A Tactical Trade Retreat Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits China's Trade War Constraint? Animal Spirits China's Trade War Constraint? Animal Spirits   Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election Business Sentiment Threatens Trump Re-Election Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 12Oil Price Constrains U.S. Policy Toward Iran Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Iran's Leverage Over Iraq Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit U.K.: Public Opinion Constrains Parliament And No-Deal Brexit U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.

Brief Market Overview The S&P 500 convulsed last week, as a slew of weaker-than-expected data shattered investors’ confidence in the longevity of the business and profit cycles. Importantly, both ISM surveys declined month-over-month, arguing that the manufacturing sector’s ails are infecting services industries (second panel, Chart 1). Chart 1The U.S. Dollar Is The Key Indicator To Monitor The U.S. Dollar Is The Key Indicator To Monitor The U.S. Dollar Is The Key Indicator To Monitor The “In Fed We Trust” doctrine will get severely tested in upcoming weeks. The Federal Reserve’s reaction function to the poor data took center stage with bond investors pricing a 75% probability of a rate cut in late October. However, our four factor EPS growth model continues to predict that earnings will remain weak for the rest of 2019 (not shown). Thus, next year’s 10% EPS growth is wishful thinking and profit growth will begin to bottom in Q1/2020 at the earliest. Absent profit growth, stocks will have to face reality and continue to drift lower. Importantly, the U.S. dollar – the great reflator – is the key determinant of both profit and global economic growth in coming quarters. The third panel of Chart 1 shows that currently that are no advanced economy central banks that have a policy rate higher than the Fed. Historically, this has been U.S. dollar bullish and has weighed on SPX momentum (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 1). It remains to be seen if aggressive Fed easing can change this relationship, stave off recession and engineer a soft landing. U.S. Equity Strategy’s view remains intact that things will get worse before they get better and therefore a cautious overall U.S. equity market stance is still warranted on a cyclical 9-12 month time horizon. NIPA VS. SPX Profit Margins On the eve of earnings season, we decided to delve deeper into corporate profits and margins, and tally where we are in the cycle, specifically with regard to profit margin drivers. To start off, we compare overall economy profits, as measured by the NIPA accounts, with SPX earnings (Chart 2). While a lot of ink has been spent on this topic and the differences between these two profit measures are more or less well recognized and understood, Kenneth A. Petrick’s commentary on the issue is worth re-reading. Without going into much detail, according to Petrick four key reasons explain the differences between NIPA and S&P 500 profits: “coverage, changing shares, industry representation and accounting principles”.1 What interests us is the leading property of NIPA profits. Importantly, NIPA profits have peaked in advance of SPX earnings in the previous three cycles. Economy-wide profits may have already peaked this cycle, warning that the SPX earnings juggernaut is long in the tooth (top panel, Chart 2). Chart 2Earnings Fatigue Earnings Fatigue Earnings Fatigue Given that NIPA profits include a broader universe of firms, small and medium enterprise (SME) profits are weighing on the overall NIPA number. The recent drubbing in economically hypersensitive S&P 400 (mid-caps) and S&P 600 (small-caps) profit estimates confirms this SME profit deterioration and forewarns that SPX profits are likely running out of fuel. While the SPX has not cracked yet courtesy of the heavyweight S&P software index, the Value Line Arithmetic (VLA, gauging the average stock) and Value Line Geometric (VLG, gauging the median stock) indexes appear to have peaked and correspond better to the NIPA profits as these indexes are broad-based are not market capitalization weighted (bottom panel, Chart 3). Chart 3Top Chart Of The Year Top Chart Of The Year Top Chart Of The Year Worryingly for the S&P 500, the VLG index is an excellent leading indicator of the SPX. Based on empirical evidence, it has led the SPX tops in the past three cycles, making it a serious contender for our “Chart Of The Year” award (top panel, Chart 3). Not only have NIPA profits likely crested, but NIPA profit margins are in steep retreat and have definitively peaked. Similar to earnings, NIPA margins lead SPX profit margins (top panel, Chart 4). Importantly, the delta between the two margin gauges is surprisingly wide. This margin gap now sits nearly three standard deviations above the historical mean and has only been wider during the dotcom bubble (bottom panel, Chart 4). Our sense is that such an acute divergence is unsustainable and will likely narrow via a mean reversion in SPX margins. Chart 4Mind The Gap Mind The Gap Mind The Gap Primary Margin Drivers Taking a deeper dive into traditional margin drivers is instructive. We use SPX margins since 1960 and prior to that we have used reconstructed SPX earnings divided by U.S. GDP (gauging SPX sales) to recreate a longer-term equity market profit margin proxy. The primary net-profit margin drivers are: Interest rates, Tax rates, Labor costs / Globalization, And corporate pricing power. Globalization has been another significant profit margin booster in the U.S. As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit maximizing projects. The bond bull market since the early 1980s has been a clear contributor to the secular advance in profits margins. Interest rates cut both ways and the big rise in long-term bond yields post World War II ate into margins. If the bond bull market is ending, then interest rates will start eating into margins anew (interest rates shown inverted, top panel, Chart 5). Intuitively, taxes and margins are also inversely correlated (tax rate shown inverted, bottom panel, Chart 5). Following the 2018 fiscal easing package, the effective corporate tax rate is now hovering in the mid-teens and explains the jump to all-time highs in SPX margins. We doubt corporate tax rates will drop further. At best, taxes will be margin-neutral in the coming years. Rising labor input costs squeeze margins and declining wages boost corporate profit margins. While labor’s share of income tentatively peaked in 1980, the late-1990s is this series’ ultimate peak and since then, it has been in a steady decline (employee compensation shown inverted, second panel, Chart 5). This labor input cost suppression has likely run its course and given that the U.S. economy is at full employment, wage inflation should also start denting margins. Globalization has been another significant profit margin booster in the U.S. As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit maximizing projects. Following the end of the Great Recession and similar to the Great Depression, de-globalization has commenced (third panel, Chart 5). Chart 5Primary... Primary... Primary... Clearly, the Sino-U.S. war has accentuated and accelerated the inward movement of countries including Korea and Japan, and has had negative knock on effects on trade as evidenced by the now nearly two-year old global growth deceleration. The longer the U.S./China trade war remains unresolved, the deeper the cracks in the foundations of global trade. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will weigh on margins at a time when final demand suffers a setback. Corporate pricing power is deteriorating, which will negatively impact profit margins, given that they are joined at the hip. The current global manufacturing recession is wreaking havoc on selling prices around the world as a number of countries are experiencing outright producer price deflation. To compete, the U.S. corporate sector is doomed to suffer the same fate, which is depressing our Corporate Pricing Power proxy, an indicator composed of 60 top-down sector price series (bottom panel, Chart 6). Chart 6...And Secondary Profit Margin Drivers ...And Secondary Profit Margin Drivers ...And Secondary Profit Margin Drivers Secondary Margin Drivers The ability of the overall corporate sector to lift prices is largely a function of firming final demand (i.e. volumes) and a falling greenback for the 40% of SPX sales that are international. This leads us to two secondary profit margin drivers: The trade-weighted U.S. dollar, And the yield curve. The ability of the overall corporate sector to lift prices is largely a function of firming final demand (i.e. volumes) and a falling greenback for the 40% of SPX sales that are international. Thus, not only is S&P 500 revenue growth and the trade-weighted U.S. dollar tightly inversely correlated, but also the same holds true for the greenback and profit margins (U.S. dollar shown inverted, top panel, Chart 6). Given that the U.S. dollar refuses to fall and is breaking out according to some Federal Reserve trade-weighted indexes, the path of least resistance for profit margins points south. The yield curve is related to the primary “interest rate” driver discussed above, but its most important signal concerns the business cycle. Empirically, profit margins mean revert at the onset of recession (yield curve shown advanced, middle panel, Chart 6). As a reminder, parts of the yield curve inverted last December, signaling that a corporate profit margin squeeze is looming. Income Inequality And Margins Finally, we make an interesting geopolitical observation. Rising profit margins are synonymous with wealth accruing to the top 1% of U.S. families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data excluding capital gains it is clear that profit margin expansion accentuates income inequality (Chart 7).2 Chart 7Income Inequality And Margins Income Inequality And Margins Income Inequality And Margins Rising profit margins lead to rising profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and potentially explains the rise of populism. Income re-distribution is therefore a rising probability event in the coming decades.3 Bottom Line: Unequivocally, all six key drivers we have identified (interest rates, tax rates, labor costs / globalization, corporate pricing power, yield curve and the U.S. dollar) are firing warning shots that profit margins have peaked and a “catch down” phase of SPX margins to NIPA margins is in store in the coming quarters.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      https://apps.bea.gov/scb/pdf/national/niparel/2001/0401cpm.pdf 2      https://eml.berkeley.edu/~saez/TabFig2017.xls 3      Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2016, available at gps.bcaresearch.com.