Labor Market

Highlights The manufacturing slowdown, on its own, is unlikely to tip the economy into a recession. The sector accounts for a small share of U.S. output and employment, and will gain a tailwind from a pick-up in global growth. A larger and more stable service sector mitigates manufacturing’s impact on the employment and consumption outlook. The bar is too high for manufacturing job losses to lift the overall unemployment rate towards recession-inducing levels. The recent divergence between alternative measures of U.S. manufacturing activity confirms the resilience of the domestic manufacturing sector relative to the rest of the world. Feature Manufacturing activity has been the most prominent casualty of the trade war between the U.S. and China, and global manufacturing PMIs have languished as tensions have intensified with no clear end in sight. Throughout the spring and early summer, manufacturing activity in the comparatively closed U.S. economy held up better than it did overseas. In August, however, the ISM Manufacturing PMI finally crossed the 50 expansion/contraction line and subsequently dipped well below it in September. Evidence of weakness was broad-based throughout September’s report and the fact that forward-looking components like new orders, new export orders and backlogs of orders all contracted further has caught our attention. Although, like most developed markets, the U.S. is a service economy, and consumption accounts for the lion’s share of its GDP, it is certainly not immune to manufacturing cycles. We are not turning a blind eye to the global manufacturing slowdown, nor downplaying its magnitude, but for now we are not overly worried about it. Regular readers know that we continue to believe that the fundamentals of the U.S. economy remain strong, supported most of all by an especially robust labor market. The manufacturing slowdown is near the top of investors’ concerns, however, so we measure how severe a manufacturing slowdown would have to be to cause serious harm to the U.S. economy. We find that the bar is high and the slowdown has low odds of getting that bad if, as we expect, global growth eventually recovers. Until a pick-up truly materializes, we remain comforted by our expectation that buoyant consumption and government spending will keep the U.S. economy out of too much trouble. David And Goliath Chart 1Services May Be Larger, But Goods Punch Harder Services May Be Larger, But Goods Punch Harder Services May Be Larger, But Goods Punch Harder Technology and globalization have revolutionized the manufacturing process and disrupted the global economic landscape. As the outsourcing of manufacturing activities to lower-cost countries has become more and more prevalent, developed markets have steadily transitioned to service economies. Since the 1950s, goods-producing sectors’ share of U.S. GDP has decreased from half to 29%. Nevertheless, a third of the economy is not negligible, especially when it swings much more wildly than the services sector, which is more than twice its size (Chart 1). In a previous report1 where we looked at the components of the U.S. GDP equation, we showed that smaller, more volatile fixed investment was considerably more likely to negate trend growth in the rest of the economy than giant, but stable, consumption. This narrative echoes the dynamics at play with the manufacturing portion of the U.S. economy. Given their greater variability, goods-producing sectors are just as likely to wipe out 2% trend growth in services as services are to wipe out 2% manufacturing growth (Table 1). Table 1Another Road To Recession The Manufacturing Slowdown's Impact On The U.S. Economy The Manufacturing Slowdown's Impact On The U.S. Economy This would be bad news if we thought the manufacturing slowdown had a lot more downside. We continue to believe in a global growth recovery narrative, however, powered by impending Chinese stimulus and revived trade negotiations. U.S. industrial production and capacity utilization both surprised to the upside in August and global growth is showing budding signs of a recovery (Chart 2). Moreover, our colleagues at Global Investment Strategy have found that industrial cycles last an average of 36 months, divided into an 18-month uptrend and an 18-month downtrend.2 Absent any major trade deterioration, the tenure of the current down leg suggests that an upturn in manufacturing activity is on its way (Chart 3). Chart 2Towards A Global Growth Pick-Up Towards A Global Growth Pick-Up Towards A Global Growth Pick-Up Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom   Another channel through which the manufacturing slowdown could hurt the U.S. economy is via manufacturing job losses and the detrimental effect they would have on overall U.S. consumption. Goods-producing sectors employ 21.1 million, including 12.9 million in manufacturing roles - a puny 14% and 8% of total nonfarm payrolls, respectively. The productivity gains that technological improvements and automated processes have unlocked over the years have allowed a modest share of U.S. workers who make tangible things to produce double their proportionate share of U.S. output. Bottom Line: Goods-producing sectors represent less than a third of U.S. GDP and less than a sixth of U.S. jobs. That’s enough for the global manufacturing slowdown to cause some domestic slowing, but not enough to end the expansion on its own. A High Pain Threshold Akin to the goods-producing sectors’ contribution to overall U.S. GDP, aggregate manufacturing payrolls tend to exhibit more volatility than aggregate services payrolls, particularly on the downside (Chart 4). Before the 1980s, because manufacturing activity accounted for a larger share of the U.S. economy and created a larger portion of jobs, a mere deceleration in the pace of payroll expansion was sufficient to tip the economy into a recession. The paradigm has shifted and it now takes a more severe manufacturing downturn to inflict real harm on the U.S. economy. Since the 1980s, no recession has occurred independent of a full-on contraction in manufacturing employment. We are not there yet, as manufacturing payrolls are still growing at a 1.1% pace. Aggregate manufacturing payrolls tend to exhibit higher volatility than aggregate services payrolls, particularly on the downside. Chart 4A Paradigm Shift A Paradigm Shift A Paradigm Shift Our Global Investment Strategy colleagues have previously shown that throughout the post-war era, whenever the 3-month moving average of the unemployment rate has risen by at least a third of a percentage point from its cyclical lows, a recession has ensued (Chart 5). The U.S. unemployment rate just made a fifty-year low and we do not expect a quick material reversal in the short run. A resilient service sector, ambitious hiring plans and elevated levels of job openings, coupled with a revival in global growth, should hold the U.S. unemployment rate in check for the time being (Chart 6). Chart 5The Recession-Inducing Level Of Unemployment... The Recession-Inducing Level Of Unemployment... The Recession-Inducing Level Of Unemployment... Chart 6...Is Not Imminent Given Strong Hiring Plans ...Is Not Imminent Given Strong Hiring Plans ...Is Not Imminent Given Strong Hiring Plans Investors are right to be concerned about the manufacturing slowdown nonetheless. To address those concerns more closely, and to challenge our own view, we calculated the number of manufacturing job losses that would be required to push the unemployment rate up to recession-inducing levels. The U.S. unemployment rate fell to a fifty-year low of 3.5% in September, tugging the 3-month moving average down to 3.6%. There are several paths the unemployment rate can take from current levels for its 3-month moving average to grow by a third of a percentage point. It may gain a linear 10 basis points a month and reach a 3.9% average in the fifth month. Myriad non-linear paths could get the moving average to 3.9% in more or less than five months. For the sake of this exercise, we do not choose a particular path, but simply assume that the 3-month moving average of the unemployment rate reaches 3.9% over three, six and twelve months. We build on the work of the economists at the Atlanta Fed and calculate the number of manufacturing job losses required to achieve a 3.9% target unemployment rate over those three timeframes. We used the Atlanta Fed Jobs Calculator’s3 default inputs, and the details and results of our subsequent calculations are summarized in Table 2. Table 2The Payroll Road To Recession The Manufacturing Slowdown's Impact On The U.S. Economy The Manufacturing Slowdown's Impact On The U.S. Economy Chart 7The Bar Is High For Manufacturing To Trigger A Recession The Bar Is High For Manufacturing To Trigger A Recession The Bar Is High For Manufacturing To Trigger A Recession Under the default assumptions of a constant participation rate and a population growth rate unchanged from the past twelve months’, it would take 313,000 job losses over three months for the overall U.S. unemployment rate to reach 3.9%. We assume that the private service sector, which shows no sign of distress, will continue to add jobs. It has done so at a historical average monthly growth rate of 0.19% but given that the overall economy has clearly slowed, we assume instead that the service sector will continue to add jobs at the slower 0.13% pace of the past twelve months. Under this more conservative assumption, the economy would gain 560,000 nonmanufacturing jobs over the next three months. Consequently, it would take 873,000 manufacturing job losses alone to offset these gains and lift the unemployment rate to 3.9% within three months. Over a six- and twelve-month horizon, the number of manufacturing job losses required to offset payroll expansion in services reaches 1.1 and 1.6 million, respectively.4 These levels of manufacturing job losses – equivalent to a 7% to 12% contraction in manufacturing payrolls - seem like a stretch in the current macroeconomic backdrop. The only time in the past seventy years when the U.S. economy experienced manufacturing job losses of this magnitude on a 3- month time period was in the first quarter of 1975, when the U.S. economy confronted a tripling of oil prices from the oil embargo. Manufacturing job losses in excess of 1.1 and 1.6 million jobs over a 6- and 12-month horizon have historically been more attainable (Chart 7). That said, manufacturing payrolls are still expanding on a 6- and 12-month horizon, albeit at a decelerating pace. Not only are manufacturing payrolls gains far from recession-inducing levels, manufacturing employment will gain a tailwind from the pick-up in global growth and turn in global industrial production cycles that we expect. These levels of manufacturing job losses – equivalent to a 7% to 12% contraction in manufacturing payrolls – seem like a stretch in the current macroeconomic backdrop. Bottom Line: The bar seems a little too high for the manufacturing slowdown alone to destroy enough jobs to tip the U.S. economy into a full-fledged recession. What Oil Shock? One can argue that the September oil shock caused by attacks on Saudi energy infrastructure will exert further pressure on global manufacturing activities. While it is true that large jumps in oil prices have often preceded recessions, we think the probability is slight that September’s event will jeopardize the prospects of a global growth recovery (Chart 8). Chart 8Oil Spikes And Recessions Oil Spikes And Recessions Oil Spikes And Recessions Chart 9U.S. Output Is Less Dependent On Oil U.S. Output Is Less Dependent On Oil U.S. Output Is Less Dependent On Oil First, not only was the September surge in oil prices tame relative to the spikes that have preceded past recessions, but the quicker-than-expected return of Saudi oil production has calmed markets. For now, the oil scare ended as quickly as it appeared. Second, higher oil prices are less of a drag on the U.S. economy than they were in the 1970s, as the country has become one of the largest oil-producing countries in the world and approaches true energy independence. The gradual shift from a manufacturing to services economy has also reduced the oil intensity of the U.S. economy to a little more than a third of what it was at the time of the 1970s oil embargo (Chart 9). Moreover, higher gasoline prices are less likely to hurt U.S. consumers now that filling the tank takes up a smaller portion of their wallets (Chart 10). As Fed Chair Jay Powell put it in a speech last week, “we now judge that a price spike would likely have nearly offsetting effects on U.S. GDP.” Chart 10Filling The Tank Takes Up A Smaller Portion Of Consumers' Wallets Filling The Tank Takes Up A Smaller Portion Of Consumers' Wallets Filling The Tank Takes Up A Smaller Portion Of Consumers' Wallets Conflicting Messages? Chart 11The ISM Manufacturing PMI's Sensitivity To Global Growth The ISM Manufacturing PMI's Sensitivity To Global Growth The ISM Manufacturing PMI's Sensitivity To Global Growth The ISM Manufacturing Composite PMI is our favored measure of U.S. manufacturing activity as its long track record allows for comparison across multiple business cycles. Although it only offers insights back to 2011, the alternative IHS Markit Manufacturing PMI is nevertheless widely watched by investors and we take note of its moves. While the recent ISM readings have been dismal, the Markit Manufacturing PMI for the U.S. accelerated to 51.1 in September. At first glance, it might seem that both readings are contradicting each other. In fact, the current divergence is not unprecedented and stems from differences in sub-component weighting methodology and in sample size and composition. The ISM reading focuses on larger multinational companies, whereas the U.S. Markit PMI polls a wider array of companies by size. Multinationals’ earnings are more directly affected by global growth developments than smaller and domestically-focused firms. Therefore, in periods of accelerating global and ex-U.S. growth, the ISM PMI tends to score higher than the Markit PMI, and vice versa (Chart 11). A still-expanding Markit Manufacturing PMI combined with a contracting ISM Manufacturing PMI simply reinforces the argument that the domestic manufacturing sector is more resilient than ex-U.S. manufacturing activity, and highlights the potential for an improvement in business confidence if the U.S. and China can reach some sort of detente. Investment Implications In spite of evidence that global manufacturing weakness is spreading, our overall assessment of the U.S. economy remains intact. Assuming an exogenous event does not snuff out the expansion, we do not expect the next recession to occur until after monetary policy turns restrictive. Since the Fed has pivoted to accommodation, along with the world’s other major central banks, we have pushed out our recession timetable back to at least the middle of 2021. We therefore think it is too early to de-risk investment portfolios. We have previously shown that bull markets tend to sprint to the finish line and we remain bullish on a 12-month cyclical horizon. Though we are not concerned that the end of the cycle is at hand, tariff tensions are squeezing trade flows and business confidence. Volatility is likely to remain elevated in the near term until trade tensions die down and the global economy demonstrates that an upturn is at hand. We are therefore neutral on equities over the tactical 0-to-3-month timeframe and recommend investors overweight cash to keep some dry powder at hand. We still recommend that investors underweight bonds in balanced portfolios.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Footnotes 1 Please see U.S. Investment Strategy Weekly Report, “If We Were Wrong”, dated April 8, 2019, available at usis.bcaresearch.com. 2 The reason underpinning this cyclicality is that most purchased goods retain some value for a certain amount of time before they need to be replaced. 3 The Atlanta Fed Jobs Calculator tool is available at https://www.frbatlanta.org/chcs/calculator?panel=1 4 Had we assumed that the nonmanufacturing payrolls continue to grow at the historical average monthly rate of 0.19% instead, the levels of manufacturing job losses required to offset the nonmanufacturing gains and lift the unemployment rate to 3.9% would be 1.1 million, 1.6 million and 2.6 million manufacturing job losses over a 3-, 6- and 12-month time horizon, respectively.

Slaying Animal Spirits Slaying Animal Spirits Business confidence peaked in March 2018 and has been in a freefall ever since, with the steepest drop taking place in recent months as the Sino-American trade war has re-escalated (CEO confidence shown inverted, top panel). Moreover, there is mounting evidence that the trade tensions are further infecting the economy beyond manufacturing including services and the consumer. Using data from the Conference Board’s Consumer Confidence survey and from the University of Michigan Sentiment survey the chart shows that consumer intentions to buy large household durable goods (shown inverted, second panel), cars (shown inverted, third panel) and homes (shown inverted, bottom panel), all have taken a massive hit of late. Historically, all three survey measures have been excellent leading indicators of the labor market and the current message is to expect a rise in the unemployment rate in coming months. Bottom Line: While we are on the sidelines on the defensive/cyclical portfolio bent we stand ready to move to a defensive over cyclical preference. Once our S&P software trailing stop gets triggered, which will move this heavyweight tech subgroup to neutral, then the broad tech sector will shift to underweight and our defensive/cyclical bent to overweight. Stay tuned.  

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

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993).

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

What Is The ISM's Message For Employment Prospects? What Is The ISM's Message For Employment Prospects? Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Worrisomely on the employment front, the surveys are in agreement (bottom panel), warning that the labor market will have trouble standing on its own two feet. Tack on the latest NFIB survey, and the news gets grimmer. The top panel shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months, which is a bearish sign for the broad equity market (second & third panels). Bottom Line: Remain cautious on the prospects of the overall equity market. Please see the most recent Weekly Report for more details.    

Highlights Portfolio Strategy Small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys, and if the Fed goes ahead and cuts interest rates in half in the coming year as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. The budding recovery in the 10-year UST yield, a rising Citi Economic Surprise Index (CESI) into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Healthy credit growth, still pristine credit quality and early signs of a recovery in the price of credit all signal that an overweight stance is warranted in the S&P banks index.  Recent Changes Last Wednesday we removed the S&P software index from the high-conviction overweight list for a 10% gain. Last Wednesday we removed the large cap size bias from the high-conviction list for a 9% gain. Table 1 The Great Rotation The Great Rotation Feature The SPX built on recent gains last week, but failed to surpass the July highs. Beneath the surface, some big sector shifts are taking place, but it is still early to declare a definitive change in trend. Dormant value stocks have awaken and are riding a high at the expense of growth and momentum names, on the back of a selloff in the bond market (Chart 1). Similarly, small cap stocks have a pulse, and started to outshine large caps. Even in a red SPX day, small cap indexes managed to close in the black (Chart 1). As a reminder with regard to our portfolio, last Wednesday we obeyed our S&P software stop and removed it from the high-conviction call list for a 10% gain, and simultaneously booked gains in the tactical large cap bias and removed it from the high-conviction call list (Chart 1). In both cases our shorter-term confidence was taken down a notch, and we intend to obey our cyclical trailing stops in both positions in order to protect gains for our portfolio (for additional details please refer to the Daily Sector Insights available here and here). Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Chart 1Healthy Rotation Healthy Rotation Healthy Rotation Worrisomely on the employment front, the surveys are in agreement (second panel, Chart 2), warning that the labor market will have trouble standing on its own two feet. This is a bearish backdrop for the broad equity market (third panel, Chart 2). Tack on the latest NFIB survey, and the news gets grimmer. Chart 3 shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months (Chart 3). Chart 2Labor Market… Labor Market… Labor Market… Chart 3…Yellow Flags …Yellow Flags …Yellow Flags This week, we update an early cyclical sector and one of its key subcomponents. Finally, the still sinking stock-to-bond ratio corroborates the ISM and NFIB surveys’ messages. Crudely put, the longer that bonds outperform stocks, the higher the chances that employment will suffer a severe setback (Chart 4). Chart 4Last Man Standing Last Man Standing Last Man Standing Granted, the labor market is a lagging indicator and typically one of the last, if not the last, shoes to drop on the eve of recession. With regard to recession, a simple thought experiment is in order. If we assume the bond market’s forecast for another 100bps of fed funds rate (FFR) cuts in the coming year as accurate, then the FFR will fall to 1.25%. This Fed policy easing will represent a 44% fall in the FFR on a year-over-year basis. Since the late 1960s recession there have not been any mid-cycle slowdowns that the Fed has engineered by clipping the FFR in half (Chart 5). Put differently, when the Fed is compelled to cut interest rates so deeply in every iteration we examined a recession followed suit. Chart 5When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason In sum, small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys and if the Fed goes ahead and cuts interest rates in half in the coming year, as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. This week, we update an early cyclical sector and one of its key subcomponents. Stick With Financials… The 45bps rise in the 10-year U.S. Treasury (UST) yield over the past two weeks has breathed life back into the S&P financials sector, and for the time being we are sticking with an overweight recommendation. While it remains to be seen how sustainable the rise in yields will be, BCA's long-held view remains that the 10-year UST yield will sell off on a cyclical 9-12 time month horizon. If this is the case then financials stocks will lead the nascent sector rotation that commenced in late-August and outperform the SPX in the coming months (top panel, Chart 6). Foreign flows had put a solid bid under U.S. bonds and artificially suppressed yields and this is at the margin reversing. In addition, the market was hoping for a 50bps rate cut from the Fed in the September meeting further weighing on the UST yield, but now the odds of that happening are nil. Finally, the Citi Economic Surprise Index (CESI) has also come out of hibernation and spiked in positive territory, evidence that economic data estimates had hit rock bottom. This slingshot recovery in the CESI is tonic for financials stocks (bottom panel, Chart 6). On the earnings front, our profit growth model has kissed off the zero line. While financials sector EPS cannot grow indefinitely at a 30%/annum clip, the turn in our three-factor macro model is a positive development (second panel, Chart 7). Chart 6Moving In Lockstep With Rates Moving In Lockstep With Rates Moving In Lockstep With Rates Chart 7Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Importantly, it stands in marked contrast to the sell side community. Analysts have been feverishly cutting EPS estimates for the sector, and now net earnings revisions have sunk to a level last hit during the great recession (middle panel, Chart 7). Similarly, relative 12-month and five-year forward profit growth forecasts are overly pessimistic. The upshot is that this lowered profit bar will be easy to surpass. With regard to shareholder friendly activities, while the overall share buyback frenzy has taken a breather, financials sector equity retirement is alive and kicking and on track to register the largest annual buyback since the short history of the data (second panel, Chart 8). If there is any sector with pent up buyback demand it is the financials sector that has been a net equity issuer until very recently still wrestling with equity dilution in the aftermath of the GFC. Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Dividend growth has been steady and in expansionary territory and the dividend payout ratio is far from waving any yellow flags. Moreover, financials yield 2.07% or 25bps higher than the 10-year UST yield and 17bps higher than the SPX, which is attractive for yield seeking investors (Chart 8). Moving on to relative valuations beyond the enticing relative dividend yield, relative price-to-book, relative forward P/E and our bombed out composite relative valuation indicator that collapsed to all-time lows suggest that financials are a screaming buy. Technicals remain oversold and also suggest that an overweight stance is warranted (Chart 9). Chart 8Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Chart 9Undervalued And Unloved Undervalued And Unloved Undervalued And Unloved Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Bottom Line: Stay overweight the S&P financials sector, that is compellingly valued, under-owned, and with promising profit prospects. … And Banks For A While Longer Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market, and we continue to recommend an above benchmark allocation in the S&P banks index. This is a global phenomenon as even the ultimate global value group, Eurozone bank equities, bottomed out on August 15 alongside their U.S. peers. While the broad financials index is levered to interest rate movements, banks – that comprise roughly 42% of the S&P financials sector – are hyper-sensitive to changes in the risk-free asset. Thus, the recent jack up in interest rates represents a profit-augmenting opportunity for this early cyclical subgroup (Chart 10) Beyond the rising price of credit, credit growth is another key industry profit driver. Our bank loan models have crested, but are still expanding at a healthy clip (second and bottom panels, Chart 11). As long as they manage to remain above the zero line, they will prove a boon to bank earnings. Specifically on the consumer front, sky high consumer confidence coupled with rising wage inflation signal that consumer credit growth prospects remain upbeat (Chart 11). Chart 10Rising Rates=Buy Banks Rising Rates=Buy Banks Rising Rates=Buy Banks Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher, likely as a delayed consequence of the dramatic fall in interest rates since last November (bottom panel, Chart 12). Chart 11Loan Growth… Loan Growth… Loan Growth… Chart 12…Prospects Are Firming …Prospects Are Firming …Prospects Are Firming Encouragingly, bank officers also reported that they were willing extenders of credit. Our in-house calculated overall gauge of loan tightening standards fell compared with last quarter, signaling that at the margin it is easier to get a loan (middle panel, Chart 12). Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine (Chart 13). The upshot is that this credit quality backdrop combined with a jump in bank return-on-equity to low double digits, should serve as catalysts to unlock excellent value (third & bottom panel, Chart 13). Nevertheless, there are two risks worth close monitoring. First, parts of the yield curve inverted last December and more recently the 10/2 yield curve slope inverted warning that the path of least resistance is lower for bank net interest margins (NIMs, middle panel, Chart 14). Chart 13Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Chart 14Two Risks To monitor Two Risks To monitor Two Risks To monitor Second, the ISM manufacturing survey fell below the boom/bust line in August for the first time since the late-2015/early-2016 manufacturing recession (bottom panel, Chart 14). Given that C&I loans are the largest loan category on the asset side of bank balance sheets, the current manufacturing recession may hurt bank profitability in two distinct ways. Not only C&I credit quality will worsen as the risk of defaults rises, but also C&I loan growth may take the back seat and weigh on bank profit growth prospects. Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Bottom Line: Continue to overweight the S&P banks index, but keep it on the downgrade watch list, acknowledging the yield curve-related potential decline in NIMs and manufacturing recession-related C&I loan growth risks. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)