Inflation/Deflation

Highlights Monetary Policy: The Fed’s message to markets is “lower for longer” until inflation expectations are re-anchored. But that guiding principle will manifest itself in only a 25 bps rate cut this month. Beyond that, we see a good chance that July’s 25 bps rate cut could be one and done. Stay short the February 2020 fed funds futures contract. TIPS: Stay overweight TIPS versus nominal Treasury securities. Our model shows that the 10-year TIPS breakeven inflation rate is 12 bps too low, and core inflation should gradually move higher in the second half of the year. Municipal Bonds: We downgrade our recommended allocation to municipal bonds from overweight to neutral, based on valuations that have become historically expensive. We continue to recommend an overweight allocation to 20-year and 30-year Aaa munis, where yields are more reasonable. Feature Chart 1Is “Lower For Longer” Working? Is "Lower For Longer" Working? Is "Lower For Longer" Working? If nothing else, the Fed is definitely staying on message. That message being that monetary policy will remain accommodative until the “re-anchoring” of inflation expectations is complete. Case in point, from the June FOMC minutes:1 Many participants further noted that longer-term inflation expectations could be somewhat below levels consistent with the Committee’s 2 percent inflation objective, or that continued weakness in inflation could prompt expectations to slip further. These developments might make it more difficult to achieve their inflation objective on a sustained basis. And last week, from a speech delivered by New York Fed President John Williams:2 Investors are increasingly viewing these low inflation readings not as an aberration, but rather a new normal. This is evidenced by a broad-based decline in market-based measures of longer-run inflation expectations … According to Williams, the solution to the low inflation expectations problem is: First, take swift action when faced with adverse economic conditions. Second, keep interest rates lower for longer. And third, adapt monetary policy strategies to succeed in the context of low r-star and the ZLB (zero-lower bound). “Lower for longer” until inflation expectations are re-anchored. That’s the Fed’s message to markets and policymakers are going out of their way to deliver it aggressively – sometimes too aggressively (see Box on page 3). The upshot is that there is some indication it might be working. BOX July Rate Cut Will Be 25 bps, And Could Be One And Done Chart B1Short The February 2020 Fed Funds Futures Contract Short The February 2020 Fed Funds Futures Contract Short The February 2020 Fed Funds Futures Contract An interesting series of events unfolded last Thursday when New York Fed President John Williams delivered a speech titled “Living Life Near the ZLB”. The speech focused on how, when interest rates are close to the zero bound, the Fed should “act quickly to lower rates at the first sign of economic distress”. Investors interpreted this dovish speech as a signal that the Fed might be gearing up for a 50 bps rate cut this month, and prices of interest rate futures rose sharply. But within a couple hours, the New York Fed released a statement saying that Williams’ comments were made in the context of an academic speech, and had nothing to do with upcoming policy actions. The New York Fed’s clarification almost certainly means that the Fed intends to cut rates by only 25 bps in July. In fact, based on the June Summary of Economic Projections where 9 out of 17 participants saw no need for rate cuts this year and nobody called for more than 50 bps of cuts in 2019, it seems unlikely that the board could achieve consensus on more than a 25 bps cut this month. Beyond this month, if global growth improves in the second half of this year as we expect, we see high odds that the Fed might only deliver a single 25 bps rate cut in July. With that in mind we continue to recommend a short position in the February 2020 fed funds futures contract (Chart B1). That position will earn 52 bps in the event of only one rate cut over the next five FOMC meetings, 26 bps in the event of two rate cuts, and 1 bp in the event of three rate cuts. Chart 1 on page 1 shows that the 10-year Treasury yield’s recent jump was driven entirely by the compensation for inflation protection. The 10-year real yield, meanwhile, is barely off its lows. The divergence makes perfect sense. A recent spate of stronger-than-expected inflation data has lifted inflation expectations, but the Fed is signaling that it will not respond by running a tighter monetary policy. That dovish forward guidance is capping the upside in real yields. If recent history repeats itself, core PCE should gradually move higher, eventually re-converging with the trimmed mean. In this week’s report we consider the outlooks for inflation and TIPS over the remainder of the year. Inflation: Modest Upside In H2 2019 As noted above, core inflation has rebounded from the extremely low readings seen earlier in the year. In fact, month-over-month core PCE came in above the Fed’s 2% target in both April and May (Chart 2). We also continue to observe a wide divergence between year-over-year core and trimmed mean PCE measures (Chart 2, top panel). If recent history repeats itself, core PCE should gradually move higher, eventually re-converging with the trimmed mean. While we only have PCE inflation data up to May, the June core CPI print was also strong (Chart 2, bottom panel). However, a closer look reveals that the bulk of June’s increase was driven by the core good component (Chart 3). We should not expect core goods to be a major driver of U.S. inflation going forward. Imports make up a large portion of consumer goods, and import prices tend to lead fluctuations in the core goods CPI. Despite the federal government’s push toward protectionism, import prices are currently contracting. This means that any strength in the core goods CPI will be transitory. Chart 2A Rebound In Core Inflation A Rebound In Core Inflation A Rebound In Core Inflation Chart 3Core CPI Components Core CPI Components Core CPI Components   Chart 4Shelter CPI Still Has Upside Shelter CPI Still Has Upside Shelter CPI Still Has Upside On the flipside, shelter – the largest component of core CPI – also increased in June (Chart 3, top panel), and we expect further acceleration in the second half of the year. The apartment rental vacancy rate is the main driver of shelter inflation, and it remains at a very low level despite the fact that a lot of multi-family units have been built during the past few years (Chart 4). The depressed vacancy rate suggests that the rental market is still not oversupplied, a message confirmed by the most recent reading from the National Multifamily Housing Council’s Apartment Market Tightness index (Chart 4, panel 2). This index has been above 50 for the past two months. Readings above 50 usually coincide with a falling vacancy rate. Overall, we conclude that core inflation will rise modestly in the second half of the year and that core PCE will eventually re-converge with the trimmed mean. Stronger inflation will be driven by the shelter and core services components. Any near-term strength in core goods inflation should be faded. Stay Overweight TIPS Versus Nominals We noted above that 10-year nominal yield’s recent jump was driven by the cost of inflation protection, rather than the real component. We can gain a broader perspective on the breakdown between the real and inflation components of Treasury yields by looking at the TIPS beta (Chart 5). The 10-year TIPS beta is calculated by regressing monthly changes in the 10-year TIPS yield on monthly changes in the 10-year nominal yield. It has been close to 0.6 for the past few years, meaning that a 1% move in the 10-year nominal yield can be roughly split between a 60 bps move in the real yield and a 40 bps move in the cost of inflation protection. The 10-year TIPS beta has been close to 0.6 for the past few years, meaning that a 1% move in the 10-year nominal yield can be roughly split between a 60 bps move in the real yield and a 40 bps move in the cost of inflation protection. We expect the TIPS beta to remain at or below current levels for the next few months. The TIPS beta tends to be low when long-maturity TIPS breakeven inflation rates are well below target. This is because the Fed will usually deploy dovish forward guidance during these periods in an attempt to goose inflation. Dovish Fed guidance makes the market less likely to price-in future monetary tightening in response to better economic data. This means that a greater proportion of the change in nominal yields will be driven by inflation expectations. Eventually, once long-maturity TIPS breakeven inflation rates move back into a “well-anchored” range between 2.3% and 2.5% (Chart 5, bottom two panels), the Fed will turn increasingly hawkish and the TIPS beta will rise. It will be some time before the 10-year TIPS breakeven inflation rate returns to its 2.3% - 2.5% range. However, our Adaptive Expectations model suggests that the rate will move higher during the next few months (Chart 6).3 Our model considers the 10-year TIPS breakeven inflation rate relative to the trailing 10-year rate of change in core CPI, the trailing 12-month rate of change in headline CPI and the New York Fed’s Underlying Inflation Gauge, with the trailing 10-year rate of change in core CPI being the most important variable. At present, our model pegs fair value for the 10-year breakeven at 1.93%, 12 bps above the current level. Chart 5Fed Guidance Keeps TIPS Beta Low Fed Guidance Keeps TIPS Beta Low Fed Guidance Keeps TIPS Beta Low Chart 6Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model   Chart 7Inflation & Commodities Inflation & Commodities Inflation & Commodities Further, every monthly core CPI print that comes in above 1.83% - the current trailing 10-year rate of change – puts slight upward pressure on our model’s fair value reading. In light of current inflation trends, further upside in the 10-year breakeven rate seems likely in the second half of the year. Finally, the 10-year TIPS breakeven inflation rate has also taken cues from oil and commodity markets in recent years (Chart 7). Our preferred broad commodity index – the CRB Raw Industrials index – remains in a tailspin, but should recover in the second half of the year alongside global growth (see section titled “Monitoring The Manufacturing Recession” below). As for oil, our commodity strategists also see upside in the second half of the year, and hold a $70/bbl price target for Brent crude.4  Bottom Line: Stay overweight TIPS versus nominal Treasury securities. Our model shows that the 10-year TIPS breakeven inflation rate is 12 bps too low, and core inflation should gradually move higher in the second half of the year. Cut Municipal Bonds To Neutral Municipal / Treasury yield ratios have tightened dramatically during the past few weeks, and municipal debt now looks quite expensive. 2-year, 5-year and 10-year Aaa-rated Municipal / Treasury yield ratios are all more than one standard deviation below average pre-crisis levels (Chart 8). Only 20-year and 30-year Aaa munis still look cheap, with yield ratios above average pre-crisis levels (Chart 8, bottom two panels). 2-year, 5-year and 10-year Aaa-rated Municipal / Treasury yield ratios are all more than one standard deviation below average pre-crisis levels. Municipal debt looks even more expensive relative to corporate credit. Chart 9 shows the average yield from the Bloomberg Barclays Investment Grade Corporate index and the yield of a Aaa muni bond with the same duration. The Muni / Corporate yield ratio is extremely stretched, and is actually close to levels that have preceded periods of strong corporate bond performance in the past. Chart 8Munis Look Expensive Munis Look Expensive Munis Look Expensive Chart 9Favor Corporate Credit Over Municipals Favor Corporate Credit Over Municipals Favor Corporate Credit Over Municipals   Bottom Line: We downgrade our recommended allocation to municipal bonds from overweight to neutral, based on valuations that have become historically expensive. We continue to recommend an overweight allocation to 20-year and 30-year Aaa munis, where yields are more reasonable. We may be seeing the first signs that manufacturing is rebounding as we head into the third quarter. We prefer corporate credit over municipals in this environment, and note that corporate bonds tend to perform well when they are as attractively valued relative to munis as they are now. Monitoring The Manufacturing Recession Chart 10Early Signs Of A Manufacturing Rebound? Early Signs Of A RebouNd In Manufacturing? Early Signs Of A RebouNd In Manufacturing? Much like in 2015/16, the ongoing global growth slowdown has taken its toll on the U.S. manufacturing sector. In fact, the National ISM Manufacturing PMI fell to 51.7 in June, from a 2018 peak of 60.7. We’ve noted in prior research that, as was the case in 2016, the global manufacturing data will likely rebound now that the Fed has adopted a more dovish policy stance and China has stepped up its rate of credit growth.5 In fact, as the Regional Fed Manufacturing PMIs have come in during the past two weeks, we may be seeing the first signs that manufacturing is rebounding as we head into the third quarter (Chart 10). The New York Fed’s PMI, released July 15, rose from -8.6 to 4.3, and three days later the Philadelphia Fed’s PMI jumped from 0.3 to 21.8. Release dates for the remaining four regional Fed surveys are shown in parentheses in Chart 10, and we will be monitoring these releases closely to see if the tentative rebound observed in the New York and Philadelphia manufacturing surveys is confirmed. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com   1 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20190619.pdf 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190718 3 For more details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, “Weak 1H19 Oil Demand Data Fuels Market Uncertainty”, dated July 18, 2019, available at ces.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com   Fixed Income Sector Performance Recommended Portfolio Specification  

Dear Client, In lieu of next week’s regular report, we will be bringing you a Special Report featuring a no-holds-barred debate over the economic and financial market outlook among three of BCA’s more bullish strategists (Doug Peta, Rob Robis, and yours truly) and three of the more bearish ones (Anastasios Avgeriou, Arthur Budaghyan, and Dhaval Joshi). Best regards, Peter Berezin, Chief Global Strategist Highlights Slowdowns are much more likely to turn into recessions when significant economic and financial imbalances are present. The U.S. does not currently suffer from any of the three major imbalances that have historically heralded recessions – rapid private-sector debt growth; excessive spending in cyclical sectors such as housing, consumer durables, and business capex; or accelerating inflation. Imbalances are larger abroad, but not to the extent that they will trigger a global recession. The combination of ongoing Chinese stimulus and the lagged effect from lower bond yields will lift global growth during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Stay overweight global equities relative to government bonds over the next 12 months. A rebound in global growth will push down the U.S. dollar later this year, creating an opportunity to increase exposure to European and EM equities. Feature Global Growth At A Critical Juncture The global economy has clearly slowed since early 2018 (Chart 1). So far, much of the weakness has been confined to the manufacturing sector. However, the service sector has softened as well (Chart 2). Chart 1The Global Economy Has Slowed... The Global Economy Has Slowed... The Global Economy Has Slowed... Chart 2...Mostly Due To Another Manufacturing Downturn ...Mostly Due To Another Manufacturing Downturn ...Mostly Due To Another Manufacturing Downturn     Regionally, the U.S. has held up somewhat better than most other economies. Nevertheless, the ISM manufacturing and nonmanufacturing indices have both declined, with the former now flirting with the 50 line. All recessions begin as slowdowns but not all slowdowns end in recessions. As we discuss below, slowdowns are much more likely to morph into recessions when financial and economic imbalances are elevated. We confine our empirical analysis to the U.S., but discuss the global context later in the report. Three Key Recessionary Imbalances Three imbalances, in particular, have often been present at the outset of U.S. recessions (Chart 3): Chart 3What Makes A Slowdown Degenerate Into A Recession: Imbalances What Makes A Slowdown Degenerate Into A Recession: Imbalances What Makes A Slowdown Degenerate Into A Recession: Imbalances Rapid private-sector debt growth: Rising debt lifts aggregate demand.1 Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. An unsustainably high level of cyclical spending: Cyclical spending includes business and residential investment, as well as spending on consumer durable goods. If spending on these categories is elevated, there is more scope for it to decline when the economy turns down. High and rising inflation. When inflation rises above the Fed’s comfort zone, the central bank normally needs to raise rates into restrictive territory.  Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. Table 1 shows every episode since 1960 when the U.S. economy has slowed significantly. To keep things simple, we define a slowdown as a 10-point drop in the ISM manufacturing index from its recent high. Table 1Episodes Of Significant Economic Slowdown When Do Slowdowns Turn Into Recessions? When Do Slowdowns Turn Into Recessions? Of the 15 slowdowns that we examined, seven culminated in recessions. An average of 2.1 of the three imbalances listed above were visible prior to recessions. However, an average of only 0.9 imbalances were present when a recession failed to materialize. This supports our claim that slowdowns are more likely to turn into recessions when significant imbalances are present. The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Equities reacted very differently in the two cases. When a recession did occur following the start of a slowdown, the S&P 500 declined by an average of 3.6% over the subsequent 12 months. When the slowdown failed to turn into a recession, the S&P rose by an average of 18.3%. In the latter case, the recovery in stocks usually coincided with a swift rebound in the ISM index. The U.S. Is Currently 0 For 3 On The Imbalance Front The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Chart 4Reasons Not To Panic About U.S. Corporate Debt (I) Reasons Not To Panic About U.S. Corporate Debt (I) Reasons Not To Panic About U.S. Corporate Debt (I) Private-Sector Debt While U.S. private nonfinancial debt has edged up slightly as a share of GDP since 2015, it remains well below its 2008 peak. In fact, the current business expansion is the only one in the post-war era where private-sector debt has failed to rise above its previous cycle high. A recent Bank of England study examined 130 recessions across 26 countries. It found private debt growth matters much more for recession risk than the level of debt.2 Granted, the composition of debt also matters: While household debt in the U.S. has fallen over the past decade, corporate debt has risen. As a share of GDP, corporate debt is now at the highest level in the post-war era. That said, despite its recent ascent, the ratio of corporate debt-to-GDP is less than two percentage points higher than it was in 2008. One drawback of comparing debt to GDP is that the former is a stock variable while the latter is a flow variable. A more sensible “apples-to-apples” approach is to look at corporate debt in relation to assets rather than GDP. If one does that, one sees that the ratio of U.S. corporate debt-to-assets is below its post-1980 average and only slightly above its post-1950 average. The interest coverage ratio, which compares the profits that companies earn for every dollar of interest that they pay, is above its historic norm (Chart 4). Corporate sector free cash flow – the difference between profits and spending on such things as labor and capital goods – remains in surplus. Every recession during the past 50 years has begun when the free cash flow balance was in deficit (Chart 5). In contrast to mortgages, which are generally held by leveraged institutions such as banks, most corporate debt is held by entities such as insurance companies, pension funds, mutual funds, and ETFs. Banks hold only 18% of corporate debt, down from 40% in 1980 (Chart 6). Thus, while high corporate debt levels could exacerbate the next recession, they are unlikely to engender it.  Chart 5Reasons Not To Panic About U.S. Corporate Debt (II) Reasons Not To Panic About U.S. Corporate Debt (II) Reasons Not To Panic About U.S. Corporate Debt (II) Chart 6Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector   Cyclical Spending Unlike a restaurant meal or a vacation, a house, office tower, factory, or automobile will usually retain some value for a while after it is purchased. If spending on cyclical items rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. By contrast, if spending on these items is subdued for a long time, pent-up demand will accumulate, requiring a period of higher production.  Recessions can result from either economic overheating or financial market overheating. As a share of GDP, cyclical spending is still far below the peaks observed during past expansions. Just as importantly, today’s low level of cyclical spending follows ten years of even lower spending. As a result, the average age of the U.S. capital stock has increased across almost all categories since 2008 (Chart 7). Most notably, the average age of U.S. homes has risen by nearly five years since 2006, the sharpest increase since the Great Depression. Despite the rebound in residential investment from its recessionary lows, the current level of homebuilding still falls short of what is necessary to keep up with household formation. As a consequence, the vacancy rate has fallen to multi-decade lows (Chart 8). Chart 7The Capital Stock Is Aging The Capital Stock Is Aging The Capital Stock Is Aging Chart 8There Is No Glut Of U.S. Homes There Is No Glut Of U.S. Homes There Is No Glut Of U.S. Homes   Inflation Recessions can result from either economic overheating or financial market overheating. Economic overheating was the dominant driver of recessions between the late 1960s to early 1980s. Rising inflation preceded the recessions of 1969-70, 1973-75, as well as the back-to-back recessions in 1980-82. Chart 9The 1990 Recession: A Bit Of Everything The 1990 Recession: A Bit Of Everything The 1990 Recession: A Bit Of Everything Overheating also contributed to the 1990 recession. After peaking in 1982, the unemployment rate fell to 5% in 1989, about one percent below its equilibrium level at the time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 9). In contrast to earlier downturns, the last two recessions were more the byproduct of financial excesses: The 2007-09 recession stemmed from the housing crash and the financial crisis it generated; the 2001 recession followed the dotcom bust, which precipitated a steep decline in capital spending. What will the next U.S. recession look like? Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. The fact that the Fed has adopted a risk-based approach to monetary policy, which puts great weight on avoiding a deflationary outcome, only raises the likelihood that inflation will eventually move higher. The good news is that this is unlikely to happen anytime soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 10). Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. As we discussed in our latest Strategy Outlook, the Fed will probably not bring rates into restrictive territory until early 2022. This gives the economy plenty of breathing space.3 The Global Dimension The discussion above has focused on the United States. To some extent, this is unavoidable. Not only is the U.S. still the world’s largest economy, but it remains at the heart of the global financial system. U.S. equities account for over half of global stock market capitalization, up from a third in the early 1990s (Chart 11). The dollar continues to be the preeminent reserve currency. As a result, U.S. financial markets drive overseas markets much more than the other way around. Chart 10No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 11The U.S. Stock Market Capitalization Is More Than Half Of Global The U.S. Stock Market Capitalization Is More Than Half Of Global The U.S. Stock Market Capitalization Is More Than Half Of Global   Chart 12 This does not mean that the rest of the world is irrelevant. The global supply chain now dominates international trade. More than half of all cross-border trade is in intermediate goods (Chart 12). Irrespective of the financial and economic imbalances discussed above, a full-blown trade war would upend the global economy, sending the U.S. and the rest of the world into recession. President Trump’s re-election prospects would plummet if U.S. unemployment rose and the stock market plunged. This is the main reason for thinking that the trade talks will ultimately produce some sort of détente. Nevertheless, a severe deterioration of trade relations remains the biggest risk to our bullish view on risk assets. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. Unlike in the United States, private debt has risen sharply as a share of GDP in several key economies over the past decade (Chart 13). Government debt is also a problem in countries such as Italy that do not have central banks which can function as reliable lenders of last resort. Chart 13 Chart 14Economies With Frothy Housing Markets Risk Having Deeper Downturns Economies With Frothy Housing Markets Risk Having Deeper Downturns Economies With Frothy Housing Markets Risk Having Deeper Downturns Cyclical spending is fairly elevated in a number of countries. Notably, residential investment stands at near record highs as a share of GDP in Canada, Australia, and New Zealand (Chart 14). Home prices are also quite frothy there. When the global economy falls into recession in two-to-three years, these economies will take it on the chin. Investment Conclusions Notwithstanding the risks noted above, we continue to maintain a bullish outlook on global equities and spread product over the next 12 months. To paraphrase Wayne Gretzky, one should invest on the basis of where the economic data is going, not where it is.4 While global growth remains anemic today, the combination of Chinese stimulus and the lagged effect from lower bond yields will boost activity during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Global equities are not super cheap, but they are not particularly expensive either. The MSCI All-Country World Index trades at 15.3-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 15). From an asset allocation perspective, one should favor stocks over bonds when the ERP is high. Chart 15AEquity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 15BEquity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13.3-times forward earnings, but it also reflects the fact that bond yields are lower overseas. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. As global growth accelerates, the dollar will start to weaken (Chart 16). EM and European equities usually outperform the global benchmark in that environment (Chart 17). We expect to upgrade stocks in these regions later this summer. Chart 16The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 17EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 2      Jonathan Bridges, Chris Jackson, and Daisy McGregor, "Down in the slumps: the role of credit in five decades of recessions," Bank Of England Staff Working Paper No. 659, (April 2017). 3      Please see Global Investment Strategy Strategy Outlook, "Third Quarter 2019 Strategy Outlook: The Long Hurrah," dated June 28, 2019. 4      According to Wayne Gretzky, his father, Walter, once advised him to “skate to where the puck is going, not to where it is.”   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 18 Tactical Trades Strategic Recommendations Closed Trades

Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession?   Recommendations Quarterly Portfolio Outlook: Precautionary Dovishness – Or Looming Recession? Quarterly Portfolio Outlook: Precautionary Dovishness – Or Looming Recession? Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Insurance Cuts, Or Full Easing Cycle? Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Consumption Fundamentals Are Strong... Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales ...Leading To Rebound In Retail Sales ...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up Manufacturing Weak, But Services Holding Up Manufacturing Weak, But Services Holding Up   Chart 5No Signs Of Usual Recession Triggers No Signs Of Usual Recession Triggers No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation China's Half-Hearted Reflation China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World China Credit Growth Affects The World China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... Fed Won't Cut As Much As Market Wants... Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise ...So Bond Yields Are Likely To Rise ...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline Investors Betting On Further Rate Decline Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls Trump Turns Softer When Market Falls Trump Turns Softer When Market Falls   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Temporary Forces Drove Inflation Downturn Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Turning On The Taps Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Chart 14 Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 15 Chart 16Downgrade Japan To Underweight Downgrade Japan To Underweight Downgrade Japan To Underweight   It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Is Consumption Enough To Prop Up U.S. Growth? Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Few Signs Of Recovery In Global Ex-U.S. Growth Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Worrisome Earnings Prospects Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Australian Equities: Close The Underweight Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Limited Downside In Yields Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Over Nominal Bonds Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth Profit Growth Should Still Outpace Debt Growth Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Watch Oil And Be Wary Of Gold Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar Stronger Global Growth Will Weigh On The Dollar Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Chart 26 Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Can Bond Yields Fall Any Further? Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy? Are Analysts Right To Be So Gloomy? Are Analysts Right To Be So Gloomy?   For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com   GAA Asset Allocation

Highlights What did the Fed just do?: It cemented the tonal about-face it began signaling in March, pushing the start date of the next recession further out into the future. Why has the Fed pivoted so sharply?: It appears that the Fed has simply shifted its priorities, and decided that a little overheating is a small price to pay to stave off a potentially more troubling deflationary scenario. What does it mean for markets and the real economy?: Additional accommodation means that the expansion will last longer than it otherwise would have, and that the growth outlook will likely improve once rate cuts begin to make themselves felt. The former will extend the bull markets in risk assets, and the latter may well make prices climb at a faster pace. Dear Client, There will be no U.S. Investment Strategy next week as we take the first of two summer breaks. U.S. Investment Strategy will return on Monday, July 15th. We wish all of our northern hemisphere clients a happy start to the summer. Best regards, Doug Peta Feature We wrapped up the third of three weeks of travel to meet face to face with clients last week. The Fed was a constant topic of conversation across all three weeks, but there was a palpable mood shift in last week’s meetings. Investors appeared to be more at ease, partially because the uncertainty ahead of the FOMC meeting had been removed, but more so from the sense, as our U.S. Bond Strategy colleagues put it, that the Fed really does have their back. Trade tensions still loom as an unknown with potentially far-reaching consequences, but risk capital now has something to lean on as it navigates tricky geopolitical currents. That is not to say that the suspicion and distrust that has shadowed this expansion and bull market for ten years has entirely disappeared. There was plenty of discomfort in the unspoken what-does-the-Fed-know-that-we-don’t sense that underlay the why-has-the-Fed-turned-so-dovish question that we were asked in nearly every meeting. As long as that nervousness remains, the bull markets will still have a wall of worry to climb, and we won’t yet have transitioned to the final euphoric phase of the advance. We continue to recommend that multi-asset investors and managers of balanced portfolios remain at least equal weight equities and spread product. What Did The Fed Just Do? Chart 1 The Fed just signaled that it has fully transitioned from the tightening bias it had at the end of last year to an easing bias that may last to the end of this one. The dot plots of FOMC participants’ fed funds rate expectations demonstrate how the transition has unfolded over the last six months. At the December meeting, 15 of 17 participants expected rate hikes in 2019, and the median voter was calling for two hikes (Chart 1, top panel). By March, the median dot was down to zero hikes, as a net nine votes migrated from two and three hikes to zero (Chart 1, middle panel). The median dot narrowly remained at zero at the June meeting, but eight voters now see the Fed cutting rates this year versus a solitary holdout expecting a lone hike (Chart 1, bottom panel). As our Global Investment Strategy colleague Peter Berezin puts it, Recessions = (Imbalances + Rate Hikes). Unsustainable imbalances are the weak link in the economic chain and as such make an economy vulnerable. They can persist for longer than an observer diligently tracking them might expect (Dornbusch), but if they really can’t go on, they won’t (Stein). A restrictive monetary policy backdrop, typically set in place via a concerted rate-hike effort, is the stress that causes the weak link to snap, triggering the recession. We do not yet see any U.S. imbalances worthy of note in either the real economy or financial markets, and the Fed has signaled that it will most likely cut the fed funds rate in July. There is no such thing as a free lunch (Friedman), though, and the dovish shift boils down to a temporal trade-off in which future growth is pulled forward to the present. Unneeded monetary stimulus carries the seeds of its own demise via the promotion of inflation pressures and the animal spirits that are the mother’s milk of imbalances. Easier policy now will ultimately lead to a higher terminal fed funds rate later, but that higher peak is likely not even a story for next year, to judge by the 2020 dots. There will be a bill for unneeded stimulus down the road, but it shouldn’t color asset-allocation decisions now. Bottom Line: The Fed’s dovish pivot, sealed in last month’s FOMC meeting, will sustain the expansion for longer than we and most macro observers expected. The market status quo will likely hold for another couple years. Why Is The Fed Pursuing Easier Policy? We see three primary reasons for the Fed’s dovish turn: countering the domestic threat posed by a potential worsening of trade tensions, making conventional recession-fighting measures more robust, and insulating the expansion from market wiggles and popular concerns that could imperil it when amplified in social echo chambers. Global trade is a solid proxy for global growth. There is a longer lag before the comparatively closed U.S. economy is affected by global conditions than its major-economy peers, but there is no such thing as decoupling and global waves eventually wash up on its shores. Higher trade barriers would raise costs across the economy as outsourcing obstacles sent corporate wage bills shooting higher, tariff costs mainly fell on end-consumer households, and the disinflationary breeze that has drifted across the developed world since global sourcing became the rule was partially blocked (Chart 2). Higher trade barriers would also reduce corporate and household incomes as export opportunities were directly limited by tariffs and quotas, and indirectly limited by reduced foreign growth. Chart 2Globalization Has Been A Disinflationary Force Globalization Has Been A Disinflationary Force Globalization Has Been A Disinflationary Force The Fed first publicly turned in a dovish direction at the beginning of January in response to the material tightening in financial conditions imposed by the fourth quarter’s market selloffs. Although equities had retraced a good bit of their losses, and corporate bonds a good bit of their spread widening, by the end of the first quarter, the Fed became incrementally more dovish at the March FOMC meeting. At the time, Fed officials repeatedly cited the perils of inflation expectations becoming unanchored on the downside. Comparatively low inflation expectations mute the potency of conventional policy measures by making the zero lower bound on interest rates a more binding constraint. We took the Fed’s focus to mean that it was wary of entering the next recession with one arm tied behind its back (Chart 3), given our personal view that it is reluctant to embark on subsequent rounds of quantitative easing when markets have been so ticklish about its efforts to unwind a tiny portion of the initial ones. Chart 3ZIRP's Power Is Directly Related To Inflation ZIRP's Power Is Directly Related To Inflation ZIRP's Power Is Directly Related To Inflation We do not believe that the Fed has caved in to market expectations, as many commentators have argued. The Fed is indifferent to market gains and losses in themselves; it cares only about how those gains and losses impact the real economy via their influence over the aggregate economic state of mind. Rampant concerns about an inverted yield curve that led to a stock selloff and a significant bout of spread widening could have the effect of denting confidence among corporate management teams and households. If they circled the wagons, squeezing hiring, capital expenditures, and consumption, a decline in confidence could become a self-fulfilling prophecy, tipping the economy into a recession that would not have otherwise occurred. We do not believe that the Fed’s turn represents a capitulation to political pressures, either. There is a natural structural tension between elected officials facing recurring election cycles that are shorter than the business cycle from which central banks take their cue. The Johnson, Nixon, Reagan and Bush I administrations all leaned on the Fed, but only the Nixon administration succeeded in altering its behavior. In our view, the Fed’s independence remains intact. Bottom Line: Incremental monetary accommodation may not be necessary, strictly speaking, but the Fed has a sound basis for providing it, and investors should not worry that the Fed’s dovish turn is a sign that it knows about problems they don’t. What Does It Mean For Investors? Chart 4 From the perspective of the simple Berezin recession equation, the Fed has pushed the beginning date of the next recession further out into the future. One or two rate cuts will delay its progress toward lifting rates to a level that restricts economic activity. The imbalances that may currently be lurking in markets and the economy are modest enough that they can easily be sustained while monetary policy settings remain accommodative. Chart 5Yields May Be About To Turn Yields May Be About To Turn Yields May Be About To Turn We expect that incremental accommodation will eventually promote overheating, and the imbalances that accompany it, but that day is presumably a couple years and a sizable equity advance away, given how bull markets tend to sprint to the finish line (Chart 4). The 10-year Treasury yield tends to move with the global manufacturing PMI, and the series that lead it have turned sharply higher. We acknowledge that we have been on the wrong side of the duration divide, but the prospects for economic weakness that would push Treasury yields even lower are slim. As our U.S. Bond Strategy colleagues wrote last week, current data suggest that the U.S. is more likely to have been experiencing a mid-cycle slowdown than the initial stages of a recession.1 They have found that Treasury yields tend to move with the aggregate global manufacturing PMI, which remains quite weak. Gold prices and highly cyclical currencies’ performance versus the yen have a good record of leading the global PMI, however, and they have turned up, suggesting that economic pressure on yields will soon ease (Chart 5).   A new round of rate cuts may be just what stocks need to end the bull market in their typical style. Recessions and bear markets tend to coincide, so pushing out the date when policy turns restrictive will have the effect of extending the equity bull market. The underlying rationale is fundamental – earnings almost always grow when the economy expands, supporting higher equity prices at equivalent multiples, and making sound borrowers even better credits – and argues for the continuation of the bull market in both equities and spread product. It may also have the animal-spirits impact of encouraging higher equity multiples and tighter credit spreads as the growth outlook improves, allowing the rate of the bull market’s advance to inflect higher. The earnings/multiple interaction may help explain bull markets’ tendency to stampede to the finish, and this one may not end until the climate turns euphoric. Stick around; the party doesn’t usually get going for a while yet.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Fed’s Got Your Back ”, dated June 25, 2019, available at usbs.bcaresearch.com.

Image Highlights Fed policy is likely to proceed in two stages: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage, which will end in late 2021, will be heaven for risk assets. The subsequent stage, which will feature a global recession, will be hell. In the end, we expect the fed funds rate to reach 4.75%, representing thirteen more 25-basis point hikes than implied by current market pricing. For the time being, investors should maintain a pro-risk stance: Overweight global equities and high-yield credit relative to government bonds and cash. Regardless of what happens to the trade negotiations, China is stimulating its economy, which will benefit global growth. As a countercyclical currency, the dollar will weaken over the next 12 months. Cyclical stocks will outperform defensives. We expect to upgrade European and EM stocks this summer. Feature Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, July 3rd at 10:00 AM EDT, where I will be discussing the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist Macro Outlook Right On Stocks, Wrong On Bonds We turned structurally bullish on global equities following December’s sell-off, having temporarily moved to the sidelines last June. This view has generally played out well. In contrast, our view that bond yields would rise this year as stocks recovered has been one gigantic flop. What went wrong with the bond view? The answer is that central banks are reacting to incoming news and data differently than in the past. As we discuss below, this has monumental implications for investment strategy. A Not So Recessionary Environment If one had been told at the start of the year that investors would be expecting the fed funds rate to fall to 1.5% by mid-2020 – with a 93% chance that the Fed would cut rates at least twice and a 62% chance it will cut rates three times in 2019 – one would probably have assumed that the U.S. had teetered into recession and that the stock market would be down on the year (Chart 1). Chart 1 Instead, the S&P 500 is near an all-time high, while credit spreads have narrowed by 145 bps since the start of the year. Outside the manufacturing sector, the economy continues to grow at an above-trend pace and the unemployment rate is below most estimates of full employment. According to the Atlanta Fed, real final domestic demand is set to increase by 2.8% in Q2, up from 1.6% in Q1. Real personal consumption expenditures are tracking to rise at a 3.7% annualized pace (Chart 2). Chart 2 So why is the Fed telegraphing rate cuts when real interest rates are barely above zero? A few reasons stand out: Global growth has slowed (Chart 3). The trade war has heated up again following President Trump’s decision to further increase tariffs on Chinese goods. Inflation expectations have fallen in the U.S. as well as around the world (Chart 4). Chart 3Global Growth Has Slowed Global Growth Has Slowed Global Growth Has Slowed Chart 4Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World   There’s More To The Story As important as they are, these three factors, even taken together, would not be enough to justify rate cuts were it not for an additional consideration: The Fed, like most other major central banks, has become increasingly worried that the neutral rate of interest – the rate consistent with full employment and stable inflation – is extremely low. This has resulted in a major shift in its reaction function. Nobody really knows exactly where the neutral rate is. According to the widely-cited Laubach Williams (L-W) model, the nominal neutral rate stands at 2.2% in the United States. This is close to current policy rates (Chart 5). The range for the longer-term interest rate dot in the Summary of Economic Projections is between 2.4% and 3.3%, which is higher than the L-W estimate. However, the range has trended lower since it was introduced in 2014 (Chart 6). Chart 5The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral Chart 6 A Fundamental Asymmetry Given that inflation expectations are quite low and there is considerable uncertainty over the level of the neutral rate, it does make some sense for policymakers to err on the side of being too dovish rather than too hawkish. This is because there is an asymmetry in monetary policy in the current environment. If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always raise rates. In contrast, if the neutral rate turns out to be very low, the decision to hike rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by over five percentage points during recessions (Chart 7). At the present rate of inflation, the zero-lower bound on interest rates would be quickly reached, at which point monetary policy would become largely impotent. Chart 7The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The asymmetry described above argues in favor of letting the economy run hot in order to allow inflation to rise. A higher inflation rate going into a recession would let a central bank push real rates deeper into negative territory before the zero bound is reached. In addition, a higher inflation rate would facilitate wage adjustments in response to economic shocks. Firms typically try to reduce costs when demand for their products and services declines, but employers are often wary of cutting nominal wages. Even though it is not fully rational, workers get more upset when they are told that their wages will fall by 2% when inflation is 1% than when they are told their wages will rise by 1% when inflation is 3%. More controversially, a modestly higher inflation rate could improve financial stability. In a low-inflation, low-nominal-rate environment, risky borrowers are likely to be able to roll over loans for an extended period of time. This could lead to the proliferation of bad debt. Chart 8Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher inflation can also cushion the blow from a burst asset bubble. For example, the Case-Shiller 20-City Composite Index fell by 34% between 2006 and 2012, or 41% in real terms. If inflation had averaged 4% over this period and real home prices had fallen by the same amount, nominal home prices would have declined by only 26%, resulting in fewer underwater mortgages (Chart 8). A New Reaction Function It is usually a mistake to base market views on an opinion about what policymakers should do rather than what they will do. On rare occasions, however, the opposite is true. And, where our Fed call is concerned, this seems to be the case. Where we fumbled earlier this year was in assuming the Fed would follow a more traditional, Taylor Rule-based monetary framework, which calls for raising rates as the output gap shrinks. Instead, the Fed has adopted a risk-based approach of the sort described above, reminiscent in many ways of the optimal control framework that Janet Yellen set out in 2012. The New Normal Becomes The New Consensus Chart 9 If one is going to conduct monetary policy in a way that errs on the side of letting the economy overheat, one should not be too surprised if the economy does overheat. Yet, the implied rate path from the futures curve suggests that investors are not taking this risk seriously. Chart 9 shows that investors are assigning a mere 5% chance that U.S. short-term rates will be above 3.5% in mid-2022. Why isn’t the market assigning more of a risk to an inflation overshoot? We suspect that most investors have bought into the consensus view that the real neutral rate is zero. According to this view, U.S. monetary policy had already turned restrictive last year when the 10-year Treasury yield climbed above 3%. If this view is correct, the recent decline in yields may stave off a recession, but it will not be enough to cause the economy to overheat. Many of the same investors also believe that deep-seated structural forces ranging from globalization, automation, demographics, to the waning power of trade unions, will all prevent inflation from rising much over the coming years even if the unemployment rate continues to fall. In other words, the Phillips curve is broken and destined to stay that way. But are these views correct? We think not.  Where Is Neutral? There is a big difference between arguing that the neutral rate may be low – and taking preemptive steps to remedy it – and arguing that it definitely is low. We subscribe to the former view, but not the latter. Our guess is that in the end, we will discover that the neutral rate is lower than in the past, but not nearly as low as investors currently think. Probably closer to 1.5% in real terms than 0%. As we discussed in detail two weeks ago, while a deceleration in trend growth has pushed down the neutral rate, other forces have pushed it up.1 These include looser fiscal policy (especially in the U.S.), a modest revival in private-sector credit demand, and dwindling labor market slack.  Since the neutral rate cannot be observed directly, the best we can do is monitor the more interest rate-sensitive sectors of the economy to see if they are cooling in a way that would be expected if monetary policy had become restrictive. For example, housing is a long-lived asset that is usually financed through debt. Hence, it is highly sensitive to changes in mortgage rates. History suggests that the recent decline in mortgage rates will spur a rebound in home sales and construction later this year (Chart 10). The fact that homebuilder confidence has bounced back this year and purchase mortgage applications have reached a cycle high is encouraging in that regard. The same goes for the fact that the vacancy rate is near an all-time low, housing starts have been running well below the rate of household formation, and the quality of mortgage lending has been quite strong (Chart 11). Chart 10Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Chart 11U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm     Nevertheless, if the rebound in housing activity fails to materialize, it would provide evidence that other factors, such as job security concerns among potential homebuyers, are overwhelming the palliative effects of lower mortgage rates.  Have Financial Markets “Trapped” Central Banks? An often-heard argument is that central banks can ill-afford to raise rates for fear of unsettling financial markets. Proponents of this argument often mention that the value of all equities, corporate bonds, real estate and other risk assets around the world exceeds $400 trillion, five times greater than global GDP. There are at least two things wrong with this argument. First, an increase in financial wealth should translate into more spending, and hence a higher neutral rate of interest. Second, as we discussed earlier this year, the feedback loop between asset prices and economic activity tends to kick in only when monetary policy has already become restrictive.2  When policy rates are close to or above neutral, further rate hikes threaten to push the economy into recession. Corporate profits inevitably contract during recessions, which hurts risk asset prices. A vicious spiral can develop where falling asset prices lead to less spending throughout the economy, leading to lower profits and even weaker asset prices. In contrast, when interest rates are below their neutral level, as we believe is the case today in the major economies, an increase in policy rates will simply reduce the odds that the economy will overheat, which is ultimately a desirable outcome. U.S. Imbalances Are Modest Chart 12U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm Recessions usually occur when rising rates expose some serious imbalances in the economy. In the U.S. at least, the imbalances are fairly modest. As noted above, housing is on solid ground, which means that mortgage rates would need to rise substantially before the sector crumbles. Equities are pricey, but far from bubble territory. Moreover, unlike in the late 1990s, the run-up in stock prices over the past five years has not led to a massive capex overhang. Corporate debt is the weakest link in the financial system, but we should keep things in perspective. Even after the recent run-up, net corporate debt is only modestly higher than it was in the late 1980s, a period where the fed funds rate averaged nearly 10% (Chart 12). Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above its long-term average, while the ratio of debt-to-assets is below its long-term average (Chart 13). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Every recession during the past 50 years has begun when the corporate sector financial balance was in deficit (Chart 14). Chart 13U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm Chart 14U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm     The Dollar, The Neutral Rate, and Global Growth In a globalized economy, capital flows can equalize, at least partially, neutral rates across countries. If any one central bank tries to raise rates – while others are standing pat or even cutting rates – the currency of the economy where rates are rising will shoot up, causing net exports to shrink and growth to slow.  In the case of the U.S. dollar, there is an additional issue to worry about, which is that there is about $12 trillion in overseas dollar-denominated debt. A stronger greenback would make it difficult for external borrowers to service their debts, leading to increased bankruptcies and defaults. Since financial and economic imbalances are arguably larger outside the U.S., a rising dollar would probably pose more of a problem for the rest of the world than for the United States. Although this is a serious risk, it is unlikely to materialize over the next 12-to-18 months, given our assumption that the dollar will weaken over this period. The U.S. dollar trades as a countercyclical currency, which is another way of saying that it tends to weaken whenever global growth strengthens (Chart 15). While the U.S. benefits from faster global growth, the rest of the world benefits even more. This stems from the fact that the U.S. has a smaller manufacturing base and a larger service sector than most other economies, which makes the U.S. a “low beta” economy. Hence, stronger global growth tends to cause capital to flow from the U.S. to the rest of the world, putting downward pressure on the greenback. Right now, China is stimulating its economy. The stimulus is a reaction to both slowing domestic growth, as well as worries about the potential repercussions of a trade war. It also reflects the fact that Chinese credit growth had sunk to a level only modestly above nominal GDP growth late last year. With the ratio of credit-to-GDP no longer rising quickly, the authorities had the luxury of suspending the deleveraging campaign (Chart 16). Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 16Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner   The combination of Chinese stimulus, the lagged effects from lower bond yields, and a turn in the global manufacturing cycle should all lift global growth in the back half of this year. This should cause the dollar to weaken. Trade War Worries Needless to say, this rosy outlook is predicated on the assumption that the trade war does not get out of hand. Our baseline envisions a “muddle through” scenario, where some sort of deal is hatched that allows the U.S. to bring down existing tariffs over time in exchange for a binding agreement by the Chinese to improve market access for U.S. companies and better secure intellectual property rights. The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a “small” trade war and a “moderate” trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system. Chart 17 What is less familiar, and much more dangerous to global finance, are nontariff barriers that effectively bar countries from accessing critical inputs and technologies. Most global trade is in the form of intermediate goods (Chart 17). If a company cannot access the global supply chain, there is a good chance it may not be able to function at all. The current travails of Huawei is a perfect example of this. A full-blown trade war would create a lot of stranded capital. The stock market represents a claim on the existing capital stock, not the capital stock that would emerge after a trade war has been fought. Stocks would plunge in this scenario, with the U.S. and most other economies succumbing to a recession. Enough voters would blame Donald Trump that he would lose the election. While such an outcome cannot be entirely dismissed, it is precisely its severity that makes it highly unlikely. Inflation: Waiting For Godot? Global monetary policy is highly accommodative at present, and will only become more so if the Fed and some other central banks cut rates. Provided that the trade war does not boil over, global growth should accelerate, putting downward pressure on the U.S. dollar. A weaker dollar will further ease global financial conditions. In such a setting, global growth is likely to remain above trend, leading to a further erosion of labor market slack. Among the major economies, the U.S. is the closest to exhausting all remaining spare capacity (Chart 18). The unemployment rate has fallen to 3.6%, the lowest level since 1969. The number of people outside the labor force who want a job as a share of the working-age population is below the level last seen in 2000. The quits and job opening rates remain near record highs. Given the erosion in slack, why has inflation not taken off? To some extent, the answer is that the Phillips curve is “kinked.” A decline in the unemployment rate from say, 8% to 5%, does little to boost inflation because even at 5%, there are enough jobless workers keen to accept what employment offers they get. It is only once the unemployment rate falls well below NAIRU that inflation starts to kick in. In the 1960s, it was not before the unemployment rate fell two percentage points below NAIRU that inflation broke out (Chart 19). Chart 18U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 19Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy   Wage growth has picked up. However, productivity growth has risen as well. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 20).  Chart 20No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral As the unemployment rate continues to drop, wage growth is likely to begin outstripping productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue thereafter. Could structural forces related to globalization, automation, demographics, and waning union power prevent inflation from rising even if labor markets tighten significantly further? We think that is unlikely. Globalization Regardless of what happens to the trade war, the period of hyperglobalization, ushered in by the fall of the Berlin Wall and China’s entry into the WTO, is over. As a share of global GDP, trade has been flat for more than ten years (Chart 21).  Chart 21Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Granted, it is not just the change in globalization that matters for inflation. The level matters too. In a highly globalized world, excess demand in one economy can be satiated with increased imports from another economy. However, this is only true if other economies have enough spare capacity. Even outside the United States, the unemployment rate in the G7 economies is approaching a record low (Chart 22). Chart 22The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows In any case, for a fairly closed economy such as the U.S., where imports account for only 15% of GDP, relative prices would need to shift a lot in order to incentivize households and firms to purchase substantially more goods from abroad. In the absence of dollar appreciation, this would require that the prices of U.S. goods increase in relation to the prices of foreign goods. In other words, U.S. inflation would still have to rise above that of the rest of the world. Automation Everyone likes to think that they are living in a special age of technological innovation. Yet, according to the productivity statistics, U.S. productivity has grown at a slower pace over the last decade than during the 1970s (Chart 23). As we argued in a past report, this is unlikely to be the result of measurement error.3  Perhaps the recent pickup in productivity growth will mark the start of a new structural trend. Maybe, but it could also just reflect a temporary cyclical revival. As labor has become less plentiful, companies have started to invest in more capital. Chart 24 shows that productivity growth and capital spending are highly correlated over the business cycle. Chart 23 Chart 24U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step   It is less clear whether total factor productivity (TFP) growth — which reflects such things as technological know-how and business practices – has turned the corner. Over the past two centuries, TFP growth has accounted for over two-thirds of overall productivity growth. Recent data suggests TFP growth in the U.S. and around the world has remained sluggish (Chart 25). Chart 25ATotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Chart 25BTotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets     Even if TFP growth does accelerate, it is not obvious that this will end up being deflationary. Increased productivity means more income, but more income means more potential spending. To the extent that stronger productivity growth expands aggregate supply, it also has the potential to raise aggregate demand. Thus, while faster productivity growth in one sector will cause relative prices in that sector to fall, this will not necessarily reduce the overall price level. Chart 26Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Chart 27 True, faster productivity growth has the ability to shift income from poor workers to rich capitalists. Since the former spend more of their income than the latter, this could slow aggregate demand growth. However, the recent trend has been in the other direction, as a tighter labor market has pushed up labor’s share of income (Chart 26). Among workers, wage growth is now higher at the bottom end of the income distribution than at the top (Chart 27). Demographics For several decades, slower population growth has reduced the incentive for firms to expand capacity. Population aging has also shifted more people into their prime saving years. The combination of lower investment demand and higher desired savings pushed down the neutral rate on interest. Chart 28The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, they are moving from being savers to dissavers. Chart 28 shows that ratio of workers-to-consumers globally has begun to decline as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The Waning Power Of Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 29). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 30). Chart 29Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Chart 30Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around   Ultimately, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Unions have influence over wages, but in the long run, central banks play the decisive role. Alt-Right Or Ctrl-Left, The Result Is Usually Inflation In a speech to the Council on Foreign Relations this week, Jay Powell noted that “The Fed is insulated from short-term political pressures – what is often referred to as our ‘independence’.”4 The operative words in his remarks were “short-term”. Powell knows full well that the Fed’s independence is not cast in stone. Even if Trump cannot legally fire or demote him, the President can choose who to nominate to the Fed’s Board of Governors. Early on in his tenure, Trump showed little interest in the workings of the Federal Reserve. He even went so far as to nominate Marvin Goodfriend – definitely no good friend of easy money – to the Fed board. Trump’s last two candidates, Stephen Moore and Herman Cain, were both political flunkies, happy to ditch their previous commitments to hard money in favor of Trump’s desire to see lower interest rates. Neither made it as far as the Senate confirmation process. Recent media reports have suggested that Trump will nominate Judy Shelton, a previously unknown economist whose main claim to fame is the promulgation of a bizarre theory about why the Fed should not pay interest on excess reserves (which, conveniently, would imply that overnight rates would need to fall to zero immediately).5  It is not clear whether Trump’s attempt to stack the Fed with lackeys will succeed. But one thing is clear: Countries with independent central banks tend to end up with lower inflation rates than countries where central banks are not independent (Chart 31). Chart 31 Whether it be Trump-style right-wing populism or left-wing populism (don’t forget, MMT is a product of the left, not the right), the result is usually the same: higher inflation. Investment Recommendations Overall Strategy The discussion above suggests the Fed will proceed along a two-stage path: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage will be heaven for risk assets. The subsequent stage will be hell. The big question is when the transition from stage one to stage two will occur. Inflation is a highly lagging indicator. It usually does not peak until a recession has begun and does not bottom until a recovery is well under way (Chart 32). Chart 32 While some measures of U.S. core inflation such as the Dallas Fed’s “trimmed mean” have moved back up to 2%, this follows a prolonged period of sub-target inflation. For now, the Fed wants both actual inflation and inflation expectations to increase. Thus, we doubt that inflation will move above the Fed’s comfort zone before 2021, and it will probably not be until 2022 that monetary policy turns contractionary. It will take even longer for inflation to rise meaningfully in the euro area and Japan. Recessions rarely happen if monetary policy is expansionary. Sustained equity bear markets in stocks, in turn, almost never happen outside of recessionary periods (Chart 33). As such, a pro-risk asset allocation, favoring global equities and high-yield credit over safe government bonds and cash, is warranted at least for the next 12 months. Chart 33Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap The key market forecast charts on the first page of this report graphically lay out our baseline forecasts for equities, bonds, currencies, and commodities. Broadly speaking, we expect a risk-on environment to prevail until the end of 2021, followed by a major sell-off in equities and credit. Equities Stocks tend to peak about six months before the onset of a recession. In the 13-to-24 month period prior to the recession, returns tend to be substantially higher than during the rest of the expansion (Table 1). We are approaching that party phase. Table 1Too Soon To Get Out Third Quarter 2019 Strategy Outlook: The Long Hurrah Third Quarter 2019 Strategy Outlook: The Long Hurrah Global equities currently trade at 15-times forward earnings. Unlike last year, earning growth estimates are reasonably conservative (Chart 34). Chart 34Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Outside the U.S., stocks trade at a respectable 13-times forward earnings. Considering that bond yields are negative in real terms in most economies – and negative in nominal terms in Japan and many parts of Europe – this implies a sizable equity risk premium.  We have yet to upgrade EM and European stocks to overweight, but expect to do so some time this summer, once we see some evidence that global growth is accelerating. International stocks should do especially well in common-currency terms over the next 12 months, if the dollar continues to trend lower, as we expect will be the case.  We are less enthusiastic about Japanese equities. First, there is still the risk that the Japanese government will needlessly raise the consumption tax in October. Second, as a risk-off currency, the yen is likely to struggle in an environment of strengthening global growth. Investors looking for exposure to Japanese stocks should favor the larger multinational exporters. At the global sector level, cyclicals should outperform defensives in an environment of stronger global growth, a weaker dollar, and ongoing Chinese stimulus. We particularly like industrials and energy. Financials should catch a bid in the second half of this year. According to the forwards, the U.S. yield curve will steepen by 38 bps over the next six months (Chart 35). Worries about an inverted yield curve will taper off. Curves will also likely steepen outside the U.S. as growth prospects improve. A steeper yield curve is manna from heaven for banks. Euro area banks trade at an average dividend yield of 6.4% (Chart 36). We are buying them as part of a tactical trade recommendation. Chart 35 Chart 36Euro Area Banks Are A Buy Euro Area Banks Are A Buy Euro Area Banks Are A Buy     Fixed Income The path to higher rates is lined with lower rates. The longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. The Fed’s dovish turn means that rates will stay lower for longer, but will ultimately go higher than we had originally envisioned. As a result, we are increasing our estimate of the terminal fed funds rate for this cycle by 50 bps to 4.75% and initiating a new trade going short the March 2022 Eurodollar futures contract. Our terminal fed funds rate projection assumes a neutral real rate of 1.5% and a peak inflation rate of 2.75%. Rates will rise roughly 50 basis points above neutral in the first half of 2022, enough to generate a recession later that year. The 10-year Treasury yield will peak at 4% this cycle. While the bulk of the increase will happen in 2021/22, yields will still rise over the next 12 months, as U.S. growth surprises on the upside. Thus, a short duration stance is warranted even in the near-to-medium term. The German 10-year yield will peak at 1.5% in 2022. We expect the U.S.-German spread to narrow modestly through to end-2021 and then widen somewhat as U.S. inflation accelerates relative to German inflation. The spread between Italian and German yields will decline in the lead-up to the global recession in 2022 and widen thereafter. U.K. gilt yields are likely to track global bond yields, although Brexit remains a source of downside risk for yields. Our base case is either no Brexit or a very soft Brexit, given that popular opinion has turned away from leaving the EU (Chart 37). Chart 37U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Chart 38U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check   We expect only a very modest increase in Japanese yields over the next five years. Japanese long-term inflation expectations are much lower than in the other major economies, which will require an extended period of near-zero rates to rectify. We expect corporate credit to outperform government bonds over the next 12 months. While spreads are not likely to narrow much from present levels, the current yield pickup is high enough to compensate for expected bankruptcy risk. Our U.S. fixed-income strategists expect default losses on the Bloomberg Barclays High-Yield index on the order of 1.25%-1.5% over the next 12 months (Chart 38). In that scenario, the junk index offers 224 bps – 249 bps of excess spread, a solid positive return that is only slightly below the historical average of 250 bps.  Currencies And Commodities The two-stage Fed cycle described above will govern the trajectory of the dollar over the next few years. In the initial stage, where global growth is accelerating and the Fed is falling ever further behind the curve in normalizing monetary policy, the dollar will depreciate. Dollar weakness will be especially pronounced against the euro and EM currencies. Commodities and commodity currencies will see solid gains. Our commodity strategists are particularly bullish on oil, as they expect crude prices to benefit from both stronger global demand and increasingly tight supply conditions. The Chinese yuan will start strengthening again if a detente is reached in the trade talks. Even if a truce fails to materialize, the Chinese authorities will likely step up the pace of credit stimulus, rather than trying to engineer a significant, and possibly disorderly, devaluation.   In the second stage, where the Fed is desperately hiking rates to prevent inflation expectations from becoming unmoored, the dollar will soar. The combination of higher U.S. rates and a stronger dollar will cause global equities to crash and credit spreads to widen. The resulting tightening in financial conditions will lead to slower global growth, which will further turbocharge the dollar. Only once the Fed starts cutting rates again in late 2022 will the dollar weaken anew. Gold should do well in the first stage of the Fed cycle and at least part of the second stage. In the first stage, gold will benefit from a weaker dollar. In the initial part of the second stage, gold prices will continue to rise as inflation fears escalate. Gold will probably weaken temporarily once real interest rates reach restrictive territory and a recession becomes all but inevitable. We recommended buying gold on April 17, 2019. The trade is up 10.8% since then. Stick with it.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 26, 2016. 4      Please see “Powell Emphasizes Fed’s Independence,” The New York Times, June 25, 2019. 5      Heather Long, “Trump’s potential Fed pick Judy Shelton wants to see ‘lower rates as fast as possible’,” The Washington Post, June 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 39 Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer The Risk Of A Recession Has Risen, But It Is Not A No Brainer The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment Lower Rates Will Help Residential Investment Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Consumers Are Spending Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... The Labor Market Is Still Doing Fine... The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Chart I-5 Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed The Rubicon Has Been Crossed The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World The Turn In Chinese Credit Will Soon Be Felt Around The World The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact China's Stimulus Is Beginning To Have An Impact China's Stimulus Is Beginning To Have An Impact   To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic The Inflation Expectations Panic The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere Central Banks Are In Easing Mode, Everywhere Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects This Much Of An Easing Bias Boosts Growth Prospects This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out Chart I-12 The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge ...As Inflation Expectations Plunge ...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Excess Money Has Turned Up Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up... Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up... Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up...   The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... ...And That The Dollar Will Turn Down... ...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow ...Especially If Repatriation Flows Slow ...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Treasurys Already Anticipate Large Dovish Surprises Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Yields Will Follow Transportation Relative To Utilities Stocks Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting 1998: Yields Rebounded As Soon As The Fed Began Cutting 1998: Yields Rebounded As Soon As The Fed Began Cutting     Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Easier Liquidity Conditions Lead To Higher Stock Prices Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Beware What Will Happen To Valuations Once Rates Rise Again Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold Strong Technical Backdrop For The Gold Strong Technical Backdrop For The Gold   Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold EM Central Banks Are Diversifying Into Gold EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline Oil Inventories Are Set To Decline Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments.   Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019   II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Deleveraging Hurts Productivity Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. Chart II-3 The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-7 Chart II-8Demographics Are Hurting Productivity Demographics Are Hurting Productivity Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-9 Chart II-10The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses A Dearth Of New Businesses A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector. Chart II-13 Chart II-14     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II- Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Chart II-16 Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. Chart II-17 In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat? How To Build A Moat? How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity. Chart II-20 Chart II-   Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22). Chart II-21 Chart II-22     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2       Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3       Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4       Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16     Productivity can be written as: Image 17     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights This week’s FOMC statement, together with the accompanying press conference, signaled a clear change in tone from the Fed. Despite the fact that underlying growth remains well above trend, a rate cut in July is now more likely than not. An additional “insurance cut” is also probable in September. Right now, rising inflation is not much of a risk. However, the Fed’s dovish turn almost guarantees that the U.S. economy will overheat. This reinforces our view that Fed policy will unfold in a two-stage process: A period of excessively easy monetary policy stretching past the next presidential election, followed by a burst of inflation that ultimately forces the Fed to hike rates. While stocks will perform well during the first stage, they will suffer during the second. We turned positive on global equities last December, but initiated a tactical hedge in May of this year. We are now extinguishing this hedge. The dollar is likely to weaken over the coming months. Cyclical equity sectors will start outperforming defensives, while international stocks will outperform their U.S. peers. We went long gold on April 17th. The trade is up 9.2% since then. Stick with it. Feature Redefining Dovish I have had the pleasure of meeting clients in the U.S. southeast this week. Unsurprisingly, the Fed has been a hot topic of discussion. Had one been told two months ago that the Federal Reserve would drop the word “patient” from the FOMC statement, one would have plausibly concluded that the Fed was about to hike rates. Little would one have known that what constitutes dovishness would change so much so quickly. Today, a dovish Fed means one that is about to cut rates. In a complete inversion of the original connotation of the term, patient is now considered hawkish. This change in tone was not immediately evident in the median 2019 interest rate dot in the June Summary of Economic Projections released this week. Just as in March, it remains stuck at 2.4%, implying a flat profile for rates over the remainder of the year. However, underneath the surface, there was a whirlwind of change. We are inclined to believe that if the Fed cuts rates in July, it will also cut rates again in September. In March, not a single FOMC member expected rates to fall this year. In the June statement, eight members penciled in rate cuts, seven of whom now expect 50 basis points of easing in the remainder of 2019 (Chart 1). The only reason the median dot did not budge was because eight members continued to cling to the expectation that the Fed would be able to keep rates at current levels throughout this year, with an additional member predicting a rate hike (down from six members who expected at least one rate hike in March). Chart 1 Tellingly, a slim majority (9 out of 17) FOMC members now expect rates to be lower in 2020 than they are currently. This tells us that some of the members who elected not to show cuts in the dot plot for 2019 have a very low bar for cutting rates. Most likely, they are looking to see how the trade talks play out before pulling the trigger on rate cuts. Our baseline expectation is that there will be enough progress in the trade negotiations at the G20 summit to keep the U.S. from imposing a further $300 billion in tariffs on Chinese imports. However, an all-encompassing deal, which rolls back existing tariffs, is not in the cards. In such a muddle-through scenario, we think a rate cut in July is still more likely than not. The fact that Jay Powell did little to push back against market expectations of rate cuts this year during his press conference this week indicates that the Fed is preparing to cut rates. How Much More Easing? Chart 2 Now that a July cut is looking increasingly like a done deal, the question is how low will rates go? Historically, when the Fed has cut rates, it has done so multiple times. Thus, it is not surprising that the market is currently assigning a 97% chance of two or more rate cuts this year and a 75% chance of three or more cuts (Chart 2). The entire futures curve is pointing to a fed funds rate of only 1.25% at end-2020 (Chart 3).   Chart 3 We are inclined to believe that if the Fed cuts rates in July, it will also cut rates again in September. However, we doubt that the Fed will deliver as much easing as is currently priced in. For one thing, it is not clear that the economy needs it. According to the Atlanta Fed’s GDPNow model, real final domestic demand is on course to accelerate from 1.5% in Q1 to 3.1% in Q2 (Chart 4). Real consumer spending is on track to rise by a whopping 3.9% in Q2. Chart 4 Chart 5Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing The only reason that headline GDP growth is set to decline in Q2 is because inventory destocking will detract from growth, having contributed to it in Q1. Keep in mind that inventory destocking is a positive indicator for future output growth because it means that final sales are running above current production levels. As we get into the second half of the year, inventories will start making a positive contribution to growth. The lagged effects from the substantial decline in bond yields will also be hitting the economy with full force. Housing, in particular, stands to benefit (Chart 5). Meanwhile, Chinese stimulus will be working its way through the global economy, likely lifting global growth in the process. Take Out Some Insurance? Chart 6Inflation Expectations Have Dropped Inflation Expectations Have Dropped Inflation Expectations Have Dropped Some monetary easing could still be justified on precautionary grounds, even if growth does seem to be holding up. The zero bound constraint remains a formidable threat. It does make sense to try to raise inflation expectations in order to allow real rates to fall deeper into negative territory in the event that a recession occurs. The fact that market-based inflation expectations have dropped sharply since last autumn has clearly influenced the Fed’s thinking (Chart 6). Right now, inflation is not a significant risk. An escalation of the trade war would push up import prices, but this is unlikely to have a lasting effect on inflation, given that Chinese imports account for only 2.5% of U.S. GDP. Indeed, a severe trade war could actually reduce U.S. inflation by causing global growth to slow which would push down commodity prices and push up the dollar. Still, we would not push the “insurance” argument too hard. Current policy rates are close to neutral according to the widely-cited Laubach Williams model, and somewhat below the “longer run” range of 2.4%-to-3.3% in the Fed's latest projections. In 1995 and 1998, the last two episodes in which the Fed engaged in precautionary easing, real rates reached 4% (Chart 7). This was well above their equilibrium level. Chart 7The Fed Embarked On Precautionary Easing In The 1990s Amid Restrictive Real Rates The Fed Embarked On Precautionary Easing In The 1990s Amid Restrictive Real Rates The Fed Embarked On Precautionary Easing In The 1990s Amid Restrictive Real Rates Of course, if it turns out that the Fed’s estimate of the real neutral rate of interest, low as it is at 0%, is still too high, continued rate cuts will be necessary. However, as we discussed last week,1 the evidence, if anything, suggests that the neutral rate is higher than what the Fed thinks. This implies that monetary policy is currently very expansionary and will only become more so if the Fed cuts rates. A Two-Stage Cycle The discussion above suggests that Fed policy will unfold as a two-stage process: A period of excessively easy monetary policy stretching past the next presidential election, followed by a burst of inflation that ultimately forces the Fed to hike rates. Chart 8No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral It is difficult to be precise about when inflation will reach a level that starts to worry the Fed. Wage growth has picked up, but so far, this has been more than offset by a cyclical revival in productivity growth. In fact, unit labor cost inflation, which leads core inflation by around 12 months, has decelerated sharply (Chart 8). However, if the unemployment rate continues to drop, wage growth will begin to outstrip productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue in late-2020 or early-2021.   Implications For Investment Strategy The Fed determines rates in the short run, but it is the economy that dictates rates in the long run. If the Fed keeps rates too low for too long, as we expect will be the case, inflation will eventually rise, forcing the Fed to hike rates. Ironically, the Fed’s decision to cut rates over the coming months means that the terminal rate during this cycle will be higher than if they had just stood pat. The longer-term investment implications for bonds are clear: Treasury yields will rise much more than expected over a horizon of two-to-three years. Investors should reduce duration risk and favor inflation-protected securities over nominal bonds. Gold should also be bought as a hedge. We went long gold on April 17th. The trade is up 9.2% since then. Stick with it. The picture for bonds is more nuanced over a shorter-term horizon of six-to-nine months. Now that the Fed has decided to cut rates, it will be difficult for yields to rise anywhere close to last year’s highs. Still, given our expectation of accelerating U.S. and global growth, the Fed is likely to cut rates by less than what is currently discounted. A modest short duration stance is thus still warranted. We turned bullish on global equities in December following the steep market sell off and have remained structurally overweight stocks throughout this entire year. We did, however, initiate a tactical hedge to short the S&P 500 on May 10 following what we regarded as an overly complacent reaction by investors to President Trump’s decision to further raise tariffs on Chinese imports. While our decision to put on the hedge initially looked prescient, the combination of the Fed’s dovish turn, a shift toward easier monetary policy by other central banks (such as the ECB this week), and growing optimism over a resolution to the trade war have caused stocks to rally above our entry point. We are thus closing this hedge for a loss of 3.8%. Ultimately, if our view that the neutral rate of interest in the U.S. is higher than widely believed turns out to be correct, equities will perform well. This is simply because a higher neutral rate implies that monetary policy is currently expansionary. Recessions rarely occur when monetary policy is accommodative, while equity bear markets rarely happen outside of recessionary periods (Chart 9). Ergo, stocks are more likely to rise than fall until interest rates increase significantly (which is unlikely to happen anytime soon). Chart 9Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 10The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As a countercyclical currency, the dollar will probably weaken over the coming months as global growth picks up (Chart 10). Cyclical equity sectors will start outperforming defensives, while international stocks will outperform their U.S. peers.     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 11 Tactical Trades Strategic Recommendations Closed Trades