Labor Market

Feature The European stock market has a hidden gem: its clothing and accessories sector. Since the turn of the millennium, the sector’s profits are up by a thousand percent (Feature Chart). In this Special Report we propose that the megatrend has further to run, as its principle driver is still very much in place. Consumption patterns are becoming more female. Feature ChartEuropean Clothes Profits Are Up A Thousand Percent! European Clothes Profits Are Up A Thousand Percent! European Clothes Profits Are Up A Thousand Percent! One of Europe’s major, and largely neglected, success stories is the dramatic rise in the percentage of the working-age population in employment. This major success story stems from another success story: the structural and broad-based increase in the female labour participation rate – which has surged from 57 percent in 1995 to 68 percent today (Chart I-2-Chart I-4). Yet the story is far from over.1 Chart I-2European Male Labour Participation Is Flat... European Male Labour Participation Is Flat... European Male Labour Participation Is Flat...   Chart I-3...But European Female Labour Participation Is Surging ...But European Female Labour Participation Is Surging ...But European Female Labour Participation Is Surging   Chart I-4...So The Percentage Of The European Population In Work Is Surging ...So The Percentage Of The European Population In Work Is Surging ...So The Percentage Of The European Population In Work Is Surging Why Job Creation Favours Women Two things are driving the megatrend in female participation. One is a paradoxical feature of the current technological revolution. As we explained in The Superstar Economy: Part 2, Artificial Intelligence (AI) excels at tasks that we perceive as difficult: those requiring the application of complex algorithms and pattern recognition to a narrowly defined goal, such as making a highly-engineered product or managing a stock portfolio. This poses a big threat to jobs in manufacturing and finance, employment sectors which happen to be male-dominated.2 Conversely, AI still struggles at tasks that we perceive as easy: those requiring adaptable movements, or reading and responding to people’s emotions and intentions. If you are good at controlling a disruptive class of 7-year olds, or calming a nervous patient before giving him an injection, your human skills are still in big demand. But education, healthcare, and social care – the employment sectors that are creating the most jobs – employ three times as many women as men. With AI still in its infancy, the established pattern of job destruction and creation will continue to favour women over men (Table I-1). Table I-1AI Is A Greater Threat To Men Buying European Clothes: An Investment Megatrend Buying European Clothes: An Investment Megatrend The other driver of the megatrend in female participation is a raft of European legislation designed to make work more family friendly: flexible working time, generous paid maternity and paternity leave, and subsidised childcare (Table I-2-Table I-4). Sharing the responsibility of childcare between mothers, fathers and external helpers has allowed tens of millions of European women to enter and remain in the labour force. Table I-2Generous Maternity Pay In Europe And Japan Buying European Clothes: An Investment Megatrend Buying European Clothes: An Investment Megatrend   Table I-3Improving Paternity Pay In Europe And Japan Buying European Clothes: An Investment Megatrend Buying European Clothes: An Investment Megatrend   Table I-4Affordable Childcare In Europe And Japan Buying European Clothes: An Investment Megatrend Buying European Clothes: An Investment Megatrend Nevertheless, the megatrend has a lot further to run. For the ultimate end-point, look at the Scandinavian countries which started legislating such policies in the early 1970s, around twenty years before the rest of Europe. As a result, in Sweden, labour force participation rates for women and men have now converged to almost identical: 81 versus 84 percent (Chart I-5). Chart I-5In Sweden, Labour Force Participation For Women And Men Is Almost Identical EU28: Labour Force Participation Rate In Sweden, Labour Force Participation For Women And Men Is Almost Identical EU28: Labour Force Participation Rate In Sweden, Labour Force Participation For Women And Men Is Almost Identical The combination of the two drivers – employment growth favouring female-dominated sectors and employment becoming more family friendly – means that net job creation in Europe will be mostly due to more women joining the workforce. An important consequence is that consumption patterns will continue to become more female. But what does that mean? How Women’s Spending Differs From Men’s Spending In the main spending categories of housing, food and healthcare, women and men tend to show near-identical spending behaviours. But there are three sub-categories where there are significant differences. Men considerably outspend women on vehicle purchases: cars account for around 8 percent of disposable income for men versus 4 percent for women. Against this, women spend more on personal care products and services: 2 percent versus 0.5 percent. This is the reason behind our long-standing successful overweight recommendation in the European personal products sector which we maintain (Chart I-6). However, the sub-category in which women outspend men by even more is clothes and accessories: estimates average around 6.5 percent for women versus 2.5 percent for men.3 Chart I-6Personal Product Profits Set To Grow Very Strongly Personal Product Profits Set To Grow Very Strongly Personal Product Profits Set To Grow Very Strongly It follows that as consumption patterns become more female, we should expect to see a steady rise in spending on clothes and accessories as a share of total consumer spending. Has this been the case? In the U.K. – where the data is easily available – the answer is yes (Chart I-7). Having said that, other factors are also at play. A generalised deflation in clothes prices (Chart I-8) is also generating a strong tailwind to sales volumes (rather than values). More about this later. Chart I-7More Real Spending On Clothes... More Real Spending On Clothes... More Real Spending On Clothes... Chart I-8Partly Because Clothes Prices Are Falling... Partly Because Clothes Prices Are Falling... Partly Because Clothes Prices Are Falling... Of course, the more compelling evidence is the thousand percent growth in the European clothes sector’s profits since the turn of the millennium. However, with the sector dominated by top brands such as LVMH and Hermes, could a more plausible explanation come from strong economic growth, until recently, in the emerging markets such as China? The answer is yes to the extent that many of the emerging economies are experiencing the same structural uptrends in female participation, and this supports our investment thesis. Still, this cannot be the main driver, because in recent years the connection between the fortunes of the emerging economies and the European clothes sector has been weak (Chart I-9).   Chart I-9The Connection Between Emerging Markets And European Clothes Is Weak The Connection Between Emerging MarketsAnd European Clothes Is Weak The Connection Between Emerging MarketsAnd European Clothes Is Weak There is another obvious question: is the market already aware of, and fully priced for, the megatrend? We think not, as most investors we meet are surprised by the structural uptrend in female participation, the on-going dynamics behind it, and the implications for consumer spending patterns. Understandably, the European clothes sector does trade at a valuation premium to the market (Chart I-10). But for many companies, the recent market hiccup has pulled down their valuation premiums to close to, or below, the long-term average from which the price has previously outperformed very strongly. Chart I-10The Valuation Premium On European Clothes Is Close To Its Long-Term Average The Valuation Premium On European Clothes Is Close To Its Long-Term Average The Valuation Premium On European Clothes Is Close To Its Long-Term Average What Is In The Clothes Basket? Pulling all of this together, the companies in our European clothes and accessories basket need to meet several criteria: A dominant or significant exposure to women’s clothes and/or accessories. A top-end brand (or brands) giving the company pricing power, and mitigating the very strong deflation in clothes prices. Avoid ‘fast fashion’. A reputation for sustainable development. A track-record of profit growth during the past decade. A forward price to earnings (PE) multiple of less than 25. A market capitalisation of at least €5 billion. On the basis of these criteria, our European clothes and accessories basket contains four names: LVMH, Kering, Luxottica, and Burberry (Table I-5). Hermes meets most of the criteria but, trading on a forward PE close to 35 is very richly valued. Table I-5The European Clothes Basket Buying European Clothes: An Investment Megatrend Buying European Clothes: An Investment Megatrend To be clear, this is not a short-term trade. Investors who buy the clothes basket outright need to have a multi-year investment horizon. Those investors who must also protect short-term performance should instead overweight the clothes basket relative to the broad market. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report “Female Participation: Another Mega-Trend” published on April 6, 2017 and available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report, “The Superstar Economy: Part 2”, January 19, 2017 available at eis.bcaresearch.com. 3 Source: Bureau of Labor Statistics Consumer Expenditure Survey 2016 via SmartAsset, and Paymentsense.

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Australian Bonds Have Outperformed Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Australian Banks Under Some Stress... Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected ...But No Credit Crunch Expected ...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls A Year Of Change In Australia? A Year Of Change In Australia? Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls A Year Of Change In Australia? A Year Of Change In Australia? The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes A Year Of Change In Australia? A Year Of Change In Australia? Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration A Year Of Change In Australia? A Year Of Change In Australia? On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates A Year Of Change In Australia? A Year Of Change In Australia? Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes A Year Of Change In Australia? A Year Of Change In Australia? Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain A Year Of Change In Australia? A Year Of Change In Australia? What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much A Year Of Change In Australia? A Year Of Change In Australia? Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Highlights Equities had a wild ride in October, ... : The S&P 500 has bounced smartly off of its October 29th lows, but the decline that preceded the bounce was unusually severe. ... that unsettled a lot of investors, and made us reconsider our constructive take on risk assets: To judge by the November 5th Barron's, and some client conversations, several technically-minded investors are unconvinced by the bounce. Nothing has changed with our equity downgrade checklist, however, ... : The fundamental picture hasn't changed at all - neither corporate revenues nor margins appear to be in any immediate difficulty; though we still expect inflation to surprise to the upside, the latest data will not push the Fed to speed up its gradual rate-hike pace; and the combination of blockbuster third-quarter earnings and October's selloff made valuations more reasonable. ... so we see no reason to downgrade equities now, though we do have the admonition of a Wall Street legend ringing in our ears: If the fundamental backdrop remained unchanged, we would be inclined to upgrade equities if the S&P 500 got back to the 2,600-2,640 range, even though we are operating with a heightened sense of vigilance befitting the lateness of the hour. Feature It has been just four weeks since we rolled out our equity downgrade checklist. We would not ordinarily devote an entire Weekly Report to reviewing all of its components, but the last four weeks have hardly been ordinary. The swiftness of the decline, and the apparent lateness of the cycle, have unsettled investors enough to make several of them reconsider just how long they want to stay at the bull-market party. At times when market action provokes emotional gut checks, it is essential for investors to have a process to fall back on. Process provides a rational, objective haven from noise and emotion, and should help foster better decision-making. Our commitment to process underpins our fondness for checklists. They will never be comprehensive - as usual, we have our minds on other important inputs - but they help to ground our thinking, and we're happy to have them when markets make wild swings. Has The Recession Timetable Speeded Up? We are not interested in recessions for their own sake - we'll let the NBER's Business Cycle Dating Committee tell us when recessions begin and end, several months after the fact - but they're poison for risk assets. Any asset allocator who can recognize them in a timely fashion has a leg up on outperforming the competition. We therefore have been repeatedly monitoring the individual components of our recession indicator (Table 1). They do not betray any more concern than they did four weeks ago. Table 1Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist The yield curve is clearly flattening, just as one would expect as the Fed gets further into a rate-hiking campaign, but it is still a comfortable distance from inverting (Chart 1). We think yields at the long end have a way to go before they stop rising, so we expect the fed funds rate will have to get well into the 3's before the 3-month bill rate can overtake the 10-year Treasury yield. The Conference Board's Leading Economic Indicator is still expanding at a robust clip (Chart 2). Finally, we estimate the fed funds rate is about a year away from exceeding the equilibrium rate, thus signaling that policy has turned restrictive. Chart 1The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... Chart 2... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging The unemployment rate continues to fall. Reversing the trend so that the three-month moving average could back up by the third of a percentage point that has unfailingly accompanied recessions (Chart 3) would require net monthly payroll additions to crater. Assuming annual population growth of 1%, and a constant labor force participation rate, net monthly job gains would have to fall to 100,000 for the three-month moving average to back up to 4% in 2020; if the pace of gains merely held at 120,000, the unemployment recession signal wouldn't be issued until 2021 (Chart 4). We applied the same conditions to the Atlanta Fed's online unemployment calculator to see what it would take for the unemployment rate to cross into the danger zone in 2019 (Table 2). Since the seven-year trend of 200,000 monthly net payroll additions would have to reverse on a dime for unemployment to issue a near-term warning, we do not foresee checking this box anytime soon. Chart 3Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Chart 4... But None Is Forthcoming ... ... But None Is Forthcoming ... ... But None Is Forthcoming ... Table 2... Unless Hiring Falls Off A Cliff Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Are Corporate Earnings Coming Under Pressure? As we mentioned last week, we view the labor market as tight and getting tighter. We thereby expect that wages are on their way to rising enough to crimp corporate margins, albeit slowly. The composite employment cost index has been in an uptrend since 2016, but it ticked lower last month, and remains well below its cyclical highs ahead of the last two recessions (Chart 5). Chart 5Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages October's global upheaval was good for the safe-haven dollar, which surged to a new year-to-date high (Chart 6). The DXY dollar index is now within 3% of the 100 level that would lead us to check the dollar strength box. Even though we're not checking the box yet, the dollar's 10% advance since mid-February will exert a modest drag on S&P 500 earnings for the next few quarters. Triple-B corporate yields have ticked a little higher since we rolled out the checklist, extending their six-year highs (Chart 7), though we still view them as manageable. Chart 6A Gentle Headwind (For Now) A Gentle Headwind (For Now) A Gentle Headwind (For Now) Chart 7Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet A rising savings rate would cancel out some of the top-line benefits from employment gains. It fell pretty sharply in the third quarter, however, amplifying the self-reinforcing effect of new hiring. It's at the bottom of the range that's prevailed since 2014 (Chart 8), but could go still lower if consumption tracks the robust consumer confidence readings, as it consistently has in the past. Chart 8Consumers Are Well-Fortified Consumers Are Well-Fortified Consumers Are Well-Fortified EM economies have become considerably more indebted since the crisis, as developed-world savings sought an outlet; corporate profits are falling; and a stronger dollar makes it harder for EM borrowers to service their USD-denominated debt. A credit crisis (or multiple credit crises) could slow global activity enough to pressure multinationals' earnings, even if the U.S. economy is mostly insulated from EM wobbles. EM equities have gotten a respite since global equities put in their year-to-date lows, and Chinese stimulus could extend EM economies a lifeline, though BCA expects that Beijing will disappoint investors hoping for a meaningful boost. We remain bearish on emerging markets as a firm, but EM distress is not anywhere near acute enough to justify ticking the box. Is Inflation Starting To Make The Fed Uneasy? There are two channels by which inflation could pose a problem for equities. The first is the Fed: if it is discomfited by what it sees in realized inflation, or perceives that inflation expectations could become unanchored, it is likely to move forcefully to quash upward pressure on prices. A forceful pace is considerably faster than a gradual pace, and would bring forward a monetary policy inflection. If policy flips from accommodative to restrictive sooner than we expect, the window for risk-asset outperformance will shrink. With all of its talk about symmetric inflation targets, the FOMC has made it clear that it will not make any attempt to defend its 2% core PCE inflation target. It is comfortable with an overshoot, and has indeed openly wished for one for much of the post-crisis era. There are limits to its indulgence, however, and we suspect that the Fed would not be comfortable if core PCE inflation were to make a new 20-year high above 2.5%. With that red line far off (Chart 9), inflation is not yet likely to encourage the Fed to quicken the pace at which it removes accommodation. Chart 9Turtles, Sloths And Inflation Turtles, Sloths And Inflation Turtles, Sloths And Inflation Inflation expectations aren't yet pressing the Fed to speed things up, either. Long-maturity TIPS break-evens have retreated slightly since mid-October, and have yet to enter the range consistent with the 2% inflation target (Chart 10). The media and the broad mass of investors don't bother with symmetric targets, or implied break-evens; they take their cues from consumer prices. A multiple haircut driven by popular inflation fears is the second channel by which inflation could halt the equity advance, but CPI remains well below the mid-3% levels that would provoke concern (Chart 11). Chart 10Stubbornly Well-Anchored Stubbornly Well-Anchored Stubbornly Well-Anchored Chart 11No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet So What's To Worry About? Irrational exuberance is always a concern after an extended period of gains, but there's no sign of it in broad market measures right now. Blockbuster earnings gains have pulled the S&P 500's forward P/E multiple back down to the 15s from its January peak above 18. Secondary measures like price-to-sales, price-to-book, and price-to-cash-flow are well below extreme levels in the aggregate. If the S&P 500 is going to get silly, it will have to surge first. That said, the latter stages of bull markets and expansions can be perilous, and we are on high alert. We continue to actively seek out any evidence that challenges our broadly constructive take on risk assets and the U.S. economy. Though we have yet to find anything compelling, an admonition from legendary technical analyst and strategist Bob Farrell has lodged in our mind. Rule number nine of Farrell's ten market rules to remember states, "When all the experts and forecasts agree - something else is going to happen." It's much more fun to bring novel views and analysis to our clients, but we don't get overly concerned about agreeing with investor consensus. It's inevitable that a lot of people will agree in the middle of extended cycles; we simply strive to be among the first to recognize the major macro inflection points and determine the optimal asset-allocation framework to benefit from them. We get a little antsy, though, when everyone knows that something is either certain to happen, or cannot happen by any stretch of the imagination. The near-unanimity with which the investment community believes that a recession cannot begin in 2019 is increasingly eating at us. We have been checking and re-checking the data, and checking and re-checking our colleagues' various models, in search of trouble, but to no avail. Even though recessions begin at economic peaks, and the economy nearly always appears to be in fine fettle when the downturn asserts itself, the sizable fiscal thrust on tap for 2019 seems to obviate the possibility of a contraction. When discussing potential risks in face-to-face meetings with clients this week, we most often cited trade tensions, as any material rollback of globalization would erode corporate profit margins and would strike at global trade, on which much of the rest of world's economies rely. A dramatic worsening of the trade picture is not our base case, but we do expect upside surprises in inflation, and an attendant upside surprise in the terminal fed funds rate. We have been considering that view mainly from the perspective of fixed-income positioning: underweight Treasuries and maintain below-benchmark duration. We also have been assuming that the FOMC would lift the fed funds rate to 3.5% at the end of 2019 via four quarter-point rate hikes, and possibly take it all the way to 4% in the first half of 2020. If it were to speed up its pace, and take the fed funds rate to 3.5% by the middle of next year, and 4% by the end, we believe financial conditions would tighten enough to choke off the expansion. Monetary policy impacts the economy with a lag, so a recession may still not begin until 2020 in that scenario, but we'd bet that an equity bear market would begin in 2019. Investment Implications Balanced investors should maintain at least an equal weight position in equities. Although our checklist is a downgrade checklist, we're alert to opportunities to upgrade as well as downgrade. As we first wrote one week before the October selloff ended, we would look to overweight equities if the S&P 500 were to dip back into the 2,600-2,640 range (Chart 12). If U.S. equities wobble again in line with our Global Investment Strategy team's MacroQuant model's near-term discomfort, investors may get another opportunity before the year is out. Chart 12Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

Highlights So What? Donald Trump's reelection depends on the timing of the next recession. Why? The midterm elections will not determine Trump's reelection chances. Rather, the timing of the next recession will. BCA's House View expects it by 2020. Otherwise, President Trump is favored to win. Trump may be downgrading "maximum pressure" on Iran, reducing the risk of a 2019 recession. Trade war with China, gridlock, and budget deficits are the most investment-relevant outcomes of U.S. politics in 2018-20. Feature The preliminary results of the U.S. midterm elections are in, with the Democrats gaining the House and failing to gain the Senate, as expected. Our view remains that the implications for investors are minimal. The policy status quo is now locked in - a gridlocked government is unlikely to produce a major change in economic policy over the next two years. While the election is to some extent a rebuke to Trump, this report argues that he remains the favored candidate for the 2020 presidential election - unless a recession occurs. A Preliminary Look At The Midterms First, the preliminary takeaways from the midterms, as the results come in: The Democrats took the House of Representatives, with a preliminary net gain of 27 seats, resulting in a 51%-plus majority, and this is projected to rise to 34 seats as we go to press Wednesday morning. This is above the average for midterm election gains by the opposition party, especially given that Republicans have held the advantage in electoral districting. Performance in the Midwest, other swing states, and suburban areas poses a threat to Trump and Republicans in 2020. Republicans held the Senate, with a net gain of at least two seats, for a 51%-plus majority. Democrats were defending 10 seats in states that Trump won in 2016. While Democrats did well in the Midwest, these candidates had the advantage of incumbency. On the state level, the Democrats gained a net seven governorships, two of them in key Midwestern states. The gubernatorial races were partly cyclical, as the Republicans had hit a historic high-water mark in governors' seats and were bound to fall back a bit. However, the Democratic victory in Michigan and Wisconsin, key Midwestern Trump states, is a very positive sign for the Democrats, since they were not incumbents in either state and had to unseat incumbent Governor Scott Walker in Wisconsin. (Their victory in Maine could also help them in the electoral college in 2020.) The governors' races also suggest that moderate Democrats are more appealing to voters than activist Democrats. Candidate Andrew Gillum's loss in Florida is a disappointment for the progressive wing of the Democratic Party.1 With the House alone, Democrats will not be able to push major legislation through. In the current partisan environment it will be nigh-impossible to reach the 60 votes needed to end debate in the Senate ("cloture"), and even then House Democrats will face a presidential veto. They will not be able to repeal Trump's tax cuts, re-regulate the economy, abandon the trade wars, resurrect Obamacare, or revive the 2015 Iranian nuclear deal. Like the Republicans after 2010, they will be trapped in the position of controlling only one half of one of the three constitutional branches. The most they can do is hold hearings and bring forth witnesses in an attempt to tarnish Trump's 2020 reelection chances. They may eventually bring impeachment articles against him, but without two-thirds of the Senate they cannot remove him from office (unless the GOP grassroots abandons him, giving senators permission to do so). U.S. equities generally move upward after midterm elections - including midterms that produce gridlock (Chart 1A & Chart 1B). However, the October selloff could drag into November. More worryingly, as Chart 1B shows, the post-election rally tends to peter out only six months after a gridlock midterm, unlike midterms that reinforce the ruling party. Chart 1AMidterm U.S. Elections Tend To Be Bullish... Midterm U.S. Elections Tend To Be Bullish... Midterm U.S. Elections Tend To Be Bullish... Chart 1B... But Markets Lose Steam Six Months Post-Gridlock ... But Markets Lose Steam Six Months Post-Gridlock ... But Markets Lose Steam Six Months Post-Gridlock However, the 2018 midterms could be mildly positive for the markets, as they do not portend any major new policies or uncertainty. Trump's proposed additional tax cuts would have threatened higher inflation and more Fed rate hikes, whereas House Democrats will not be able to raise taxes or cut spending alone. Bipartisan entitlement reform seems unlikely in 2018-20 given the acrimony of the two parties and structural factors such as inequality and populism. An outstanding question is health care, which Republicans left unresolved after failing to repeal Obamacare, and which exit polls show was a driving factor behind Democratic victories. Separately, as an additional marginal positive for risk assets, the Trump administration has reportedly granted eight waivers to countries that import Iranian oil. We have signaled that Trump's "maximum pressure" doctrine poses a key risk for markets due to the danger of an Iran-induced oil price shock. A shift toward more lax enforcement reduces the tail-risk of a recession in 2019 (Chart 2). Of course, the waivers will expire in 180 days and may be a mere ploy to ensure smooth markets ahead of the midterm election, so the jury is still out on this issue. Chart 2Rapid Increases In Oil Prices Tend To Precede Recessions The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast This brings us to the main focus of this report: what do the midterms suggest about the 2020 election? Bottom Line: The midterm elections have produced a gridlocked Congress. Trump can continue with his foreign policy, most of his trade policy, his deregulatory decrees, and his appointment of court judges with limited interference from House Democrats. The only thing the Democrats can prevent him from doing is cutting taxes further. He tends to agree with Democrats on the need for more spending! While the U.S. market could rally on the back of this result, we do not see U.S. politics being a critical catalyst for markets going forward. On balance, a gridlocked result brings less uncertainty than would otherwise be the case, which is positive for markets in the short term. The Midterms And The 2020 Election There is a weak relationship at best between an opposition party's gains in the midterms and its performance in the presidential election two years later. Given that the president's party almost always loses the midterms - and yet that incumbent presidents tend to be reelected - the midterm has little diagnostic value for the presidential vote, as can be seen in recent elections (Chart 3A & Chart 3B). Chart 3AMidterm Has Little Predictive Power For Presidential Popular Vote ... The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Chart 3B... Nor For Presidential Electoral College Vote The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Nevertheless, historian Allan Lichtman has shown that since 1860, a midterm loss is marginally negative for a president's reelection chances.2 And for Republicans in recent years, losses in midterm elections are very weakly correlated with Republican losses of seats in the electoral college two years later (Chart 4). Chart 4Republican Midterm Loss Could Foreshadow Electoral College Losses The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Still, this midterm election does not give any reason to believe that Trump's reelection chances have been damaged any more than Ronald Reagan's were after 1982, or Bill Clinton's after 1994, or Barack Obama's after 2010. All three of these presidents went on to a second term. A midterm loss simply does not stack the odds against reelection. Why are midterm elections of limited consequence for the president? They are fundamentally different from presidential elections. For instance, "the buck stops here" applies to the president alone, whereas in the midterms voters often seek to keep the president in check by voting against his party in Congress.3 Despite the consensus media narrative, the president is not that unpopular. Trump's approval rating today is about the same as that of Clinton and Obama at this stage in their first term (Chart 5). This week's midterm was not a wave of "resistance" to Trump so much as a run-of-the-mill midterm in which the president's party lost seats. Its outcome should not be overstated. Bottom Line: There is not much correlation between midterms and presidential elections. The best historians view it as a marginal negative for the incumbent. This result is not a mortal wound for Trump. Chart 5President Trump Is Hardly Losing The Popularity Contest The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast 2020: The Recession Call Is The Election Call The incumbent party has lost the White House every single time that a recession occurred during the campaign proper (Chart 6).4 The incumbent party has lost 50%-60% of the time if recession occurred in the calendar year before the election or in the first half of the election year. Chart 6A 2020 Recession Is Trump's Biggest Threat A 2020 Recession Is Trump's Biggest Threat A 2020 Recession Is Trump's Biggest Threat This is a problem for President Trump because the current economic expansion is long in the tooth. In July 2019, it will become the longest running economic expansion in U.S. history, following the 1991-2001 expansion. The 2020 election will occur sixteen months after the record is broken, which means that averting a recession over this entire period will be remarkable. BCA's House View holds that 2020 is the most likely year for a recession to occur. The economy is at full employment, inflation is trending upwards, and the Fed's interest rate hikes will become restrictive sometime in 2019. The yield curve could invert in the second half of 2019 - and inversion tends to precede recession by anywhere from 5-to-16 months (Table 1). No wonder Trump has called the Fed his "biggest threat."5 Table 1Inverted Yield Curve Is An Ominous Sign The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The risks to this 2020 recession call are probably skewed toward 2021 instead of 2019. The still-positive U.S. fiscal thrust in 2019 and possibly 2020 and the Trump administration's newly flexible approach to Iran sanctions, if maintained, reduce the tail-risk of a recession in 2019. If there is not a recession by 2020, Trump is the favored candidate to win. First, incumbents win 69% of all U.S. presidential elections. Second, incumbents win 80% of the time when the economy is not in recession, and 76% of the time when real annual per capita GDP growth over the course of the term exceeds the average of the previous two terms, which will likely be the case in 2020 unless there is a recession (Chart 7). Chart 7Relative Economic Performance Could Give Trump Firepower Relative Economic Performance Could Give Trump Firepower Relative Economic Performance Could Give Trump Firepower The above probabilities are drawn from the aforementioned Professor Allan Lichtman, at American University in Washington D.C., who has accurately predicted the outcome of every presidential election since 1984 (except the disputed 2000 election). Lichtman views presidential elections as a referendum on the party that controls the White House. He presents "13 Keys to the Presidency," which are true or false statements based on historically derived indicators of presidential performance. If six or more of the 13 keys are false, the incumbent will lose. On our own reading of Lichtman's keys, Trump is currently lined up to lose a maximum of four keys - two shy of the six needed to unseat him (Table 2). This is a generous reading for the Democrats: Trump's party has lost seats in the midterm election relative to 2014; his term has seen sustained social unrest; he is tainted by major scandal; and he is lacking in charisma. Yet on a stricter reading Trump only has one key against him (the midterm). Table 2Lichtman's Thirteen Keys To The White House* The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast What would it take to push Trump over the edge? Aside from a recession (which would trigger one or both of the economic keys against him), he would need to see two-to-four of the following factors take shape: a serious foreign policy or military failure, a charismatic Democratic opponent in 2020, a significant challenge to his nomination within the Republican Party, or a robust third party candidacy emerge. In our view, none of these developments are on the horizon yet, though they are probable enough. For instance, it is easy to see Trump's audacious foreign policy on China, Iran, and North Korea leading to a failure that counts against him. Thus, as things currently stand, Trump is the candidate to beat as long as the economy holds up. What about impeachment and removal from office prior to 2020? As long as Trump remains popular among Republican voters he will prevent the Senate from turning against him (Chart 8). What could cause public opinion to change? Clear, irrefutable, accessible, "smoking gun" evidence of personal wrongdoing that affected Trump's campaigns or duties in office. Nixon was not brought down until the Watergate tapes became public - and that required a Supreme Court order. Only then did Republican opinion turn against him and expose him to impeachment and removal - prompting him to resign. Chart 8Trump Cannot Be Removed From Office The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast All that being said, Trump tends to trail his likeliest 2020 adversaries in one-on-one opinion polling. Given our recession call, we would not dispute online betting markets giving Trump a less-than-50% chance of reelection at present (Chart 9). The Democratic selection process has hardly begun: e.g. Joe Biden could have health problems, and Michelle Obama, Oprah Winfrey, or other surprise candidates could decide to run. The world will be a different place in 2020. Bottom Line: The recession call is the election call. If BCA is right about a recession by 2020, then Trump will lose. If we are wrong, then Trump is favored to win. Chart 9A Strong Opponent Has Yet To Emerge The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Is It Even Possible For Trump To Win Again? Election Scenarios Is it demographically possible for Trump to win? Yes. In 2016 BCA dubbed Trump's electoral strategy "White Hype," based on his apparent attempt to increase the support and turnout of white voters, primarily in "Rust Belt" battleground states. While Republican policy wonks might have envisioned a "big tent" Republican Party for the future, demographic trends in 2016 suggested that this strategy was premature. Indeed, drawing from a major demographic study by the Center for American Progress and other Washington think tanks,6 we found that a big increase in white turnout and support was the only 2016 election scenario in which a victory in both the popular vote and electoral college vote was possible. In other words, while "Minority Outreach" have worked as a GOP strategy in the future, Donald Trump's team was mathematically correct in realizing that only White Hype would work in the actual election at hand. This strategy did not win Trump the popular vote, but it did secure him the requisite electoral college seats, notably from the formerly blue of Wisconsin, Michigan, and Pennsylvania. Comparing the 2016 results with our pre-election projections confirms this point: Trump won the very swing states where he increased white GOP support and lost the swing states where he did not. Pennsylvania is the notable exception, but he won there by increasing white turnout instead of white GOP support.7 Can Trump do this again? Yes, but not easily. Map 1 depicts the 2016 election results with red and blue states, plus the percentage swing in white party support that would have been necessary to turn the state to the opposite party (white support for the GOP is the independent variable). In Michigan, a 0.3% shift in the white vote away from Republicans would have deprived Trump of victory; in Wisconsin and Pennsylvania, a 0.8% shift would have done the same; in Florida, a 1.5% change would have done so. Map 1The 'White Hype' Strategy Narrowly Worked In 2016 The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Critically, the country's demographics have changed significantly since 2016 - to Trump's detriment. The white eligible voting population in swing states will have fallen sharply from 81% of the population to 76% of the population by 2020 (Chart 10). Chart 10Demographic Shift Does Not Favor Trump The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Thus, to determine whether Trump still has a pathway to victory, we looked at eight scenarios, drawing on the updated Center for American Progress study. The assumptions behind the scenarios in Table 3 are as follows: Status Quo - This replicates the 2016 result and projects it forward with 2020 demographics. 2016 Sans Third Party - Replicates the 2016 result but normalizes the third party vote, which was elevated that year. Minority Revolt - In this scenario, Hispanics, Asians, and other minorities turn out in large numbers to support Democrats, even with white non-college educated voters supporting Republicans at a decent rate. The Kanye West Strategy - Trump performs a miracle and generates a swing of minority voters in favor of Republicans. Blue Collar Democrats - White non-college-educated support returns to 2012 norms, meaning back to Democrats. Romney's Ghost - White college-educated support returns to 2012 levels. White Hype - White non-college-educated support swings to Republicans. Obama versus Trump - White college-educated voters ally with minorities in opposition to a surge in white non-college-educated voters for Republicans. Table 3Assumptions For Key Electoral Scenarios In 2020 The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The results show that Trump's best chance at remaining in the White House is still White Hype, as it is still the only scenario in which Trump can statistically win a victory in the popular vote (Chart 11). Another pathway to victory is the "2016 Sans Third Party" scenario. But this scenario still calls for White Hype, since a third party challenger is out of his hands (Chart 12).8 Chart 11'White Hype' May Be Only Way To Secure Both Popular And Electoral College Vote... The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast   Chart 12... Although Moving To The Center Could Still Yield Electoral College Vote The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast However, the data show that Trump cannot win merely by replicating his white turnout and support from 2016, due to demographic changes wiping away the thin margins in key swing states. He needs some additional increases in support. These increases will ultimately have to be culled from his record in office - which reinforces the all-important question of the timing of recession, but also raises the question of whether Trump will move to the center to woo the median voter. In the "Kanye West" and "Romney's Ghost" scenarios, Trump wins the electoral college by broadening his appeal to minorities and college-educated white voters. This may sound far-fetched, but President Clinton reinvented himself after the "Republican Revolution" of 1994 by compromising with Republicans in Congress. The slim margins in the Midwest suggest that the probability of Trump shifting to the middle is not as low as one might think. Especially if there is no recession. Independents remain the largest voting block - and they have not lost much steam, if any, since 2016. Moreover, the number of independents who lean Republican is in an uptrend (Chart 13). Without a recession, or a failure on Lichtman's keys, Trump will likely broaden his base. Chart 13Trump Shows Promise Among Independents Trump Shows Promise Among Independents Trump Shows Promise Among Independents Bottom Line: Trump needs to increase white turnout and GOP support beyond 2016 levels in order to win 2020. Demographics will not allow a simple repeat of his 2016 performance. However, he may be able to generate the requisite turnout and support by moving to the center, courting college-educated whites and even minorities. His success will depend on his record in office. Investment Implications What are the implications of the above findings for 2018-20 and beyond? The Rust Belt states of Michigan, Pennsylvania, and Wisconsin will become pseudo-apocalyptic battlegrounds in 2020. The Democrats must aim to take back all three to win the White House, as they cannot win with just two alone.9 They are likely to focus on these states because they are erstwhile blue states and the vote margin is so slim that the slightest factors could shift the balance - meaning that Democrats could win here without a general pro-Democratic shift in opinion that hurts Trump in other key swing states such as Florida, North Carolina, or Arizona. The "Blue Collar Democrat" scenario, for instance, merely requires that white non-college-educated voters return to their 2012 level of support for Democrats. Joe Biden is the logical candidate, health permitting, as he is from Pennsylvania and was literally on the ballot in 2012! Moreover, these states are the easiest to flip to the Democratic side via the woman vote. In Michigan, a 0.5% swing of women to the Democrats would have turned the state blue again; in Pennsylvania that number is 1.6% and in Wisconsin it is 1.7% (Table 4). These are the lowest of any state. Women from the Midwest or with a base in the Midwest - such as Michelle Obama or Oprah Winfrey - would also be logical candidates. Table 4Women Voters May Hold The Balance The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The Democrats could also pursue a separate or complementary strategy by courting African American turnout and support, especially in Florida, Georgia, and North Carolina. But it is more difficult to flip these states than the Midwestern ones. With the Rust Belt as the fulcrum of his electoral strategy and reelection, Trump has a major incentive to maintain economic nationalism over the coming two years. Trump may be more pragmatic in the use of tariffs, and will certainly engage in talks with China and others, but he ultimately must remain "tough" on trade. He has fewer constraints in pursuing trade war with China than with Europe. For the same Rust Belt reason, the Democrats, if they get into the Oval Office, will not be overly kind to the "butchers of Beijing," as President Clinton called the Chinese leadership in the 1992 presidential campaign (after the 1989 Tiananmen Square incident). Hence we are structurally bearish U.S.-China relations and related assets. Interestingly, if Trump moves to the middle, and tones down "white nationalism" in pursuit of college-educated whites and minorities, then he would have an incentive to dampen the flames of social division ahead of 2020. The key is that in an environment without recession, Trump has the option of courting voters on the basis of his economic and policy performance alone. Whereas if he is seen fanning social divisions, it could backfire, as Democrats could benefit from a sense of national crisis and instability in a presidential election. Either way, culture wars, controversial rhetoric, identity politics, unrest, and violence will continue in the United States as the fringes of the political spectrum use identity politics and wedge issues to rile up voters.The question is how the leading parties and their candidates handle it. What about after 2020? Are there any conclusions that can be drawn regardless of which party controls the White House? The two biggest policy certainties are that fiscal spending will go up and that generational conflict will rise. On fiscal spending, Trump was a game changer by removing fiscal hawkishness from the Republican agenda. Democrats are not proposing fiscal responsibility either. The most likely areas of bipartisan legislation in 2018-20 are health care and infrastructure - returning House Speaker Nancy Pelosi mentioned infrastructure several times in her election-night speech - which would add to the deficit. The deficit is already set to widen sharply, judging by the fact that it has been widening at a time when unemployment is falling. This aberration has only occurred during the economic boom of the 1950s and the inflation and subsequent stagflation beginning in the late 1960s (Chart 14). The current outlook implies a return of the stagflationary scenario. In the late 1960s, the World War I generation was retiring, lifting the dependent-to-worker ratio and increasing consumption relative to savings. Today, as Peter Berezin of BCA's Global Investment Strategy has shown, the Baby Boomers are retiring with a similar impact. Chart 14The Deficit Is Blowing Out Even Without A Recession The Deficit Is Blowing Out Even Without A Recession The Deficit Is Blowing Out Even Without A Recession Trump made an appeal to elderly voters in the midterms by warning that unfettered immigration and Democratic entitlement expansions would take away from existing senior benefits. By contrast, Democrats will argue that Republicans want to cut benefits for all to pay for tax cuts for the rich, and will try to activate Millennial voters on a range of progressive issues that antagonize older voters. The result is that policy debates will focus more on generational differences. Mammoth budget deficits - not to mention trade war - will be good for inflation, good for gold, and a headwind for U.S. government bonds and the USD as long as the environment is not recessionary. The greatest policy uncertainties are health care and immigration. These are the two major outstanding policy issues that Republicans and Democrats will vie over in 2018 and beyond. While President Trump could achieve something with the Democrats on either of these issues with some painful compromises, it is too soon to have a high conviction on the outcome. But assuming that over the coming years some immigration restrictions come into play and that some kind of public health care option becomes more widely available, there are two more reasons to expect inflation to trend upward on a secular basis. Also on a secular basis, defense stocks stand to benefit from geopolitical multipolarity, especially U.S.-China antagonism. Tech stocks stand to suffer due to the trade war and an increasingly bipartisan consensus that this sector needs to be regulated.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   1 Furthermore, victories on the state level, if built upon in the 2020 election, could give the Democrats an advantage in gerrymandering, i.e. electoral redistricting, which is an important political process in the United States. 2 Please see Allan J. Lichtman, Predicting The Next President: The Keys To The White House 2016 (New York: Rowman and Littlefield, 2016). 3 Please see Joseph Bafumi, Robert S. Erikson, and Christopher Wlezien, "Balancing, Generic Polls and Midterm Congressional Elections," The Journal of Politics 72:3 (2010), pp. 705-19. 4 Please see footnote 2 above. 5 Please see Sylvan Lane, “Trump says Fed is his ‘biggest threat,’ blasting own appointees,” The Hill, October 16, 2018, available at thehill.com. 6 Please see Rob Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, dated April 14, 2018, available at www.americanprogress.org. 7 In several cases, he did not have to lift white support by as much as we projected because minority support for the Democrats dropped off after Obama left the stage. 8 Interestingly, however, this scenario would result in an electoral college tie! Since the House would then vote on a state delegation basis, it would likely hand Trump the victory (and Pence would also win the Senate). 9 However, if they win Pennsylvania plus one electoral vote in Maine, they can win the electoral college with either Michigan or Wisconsin.

Highlights The End Of APP?: Economic growth in the euro area has lost momentum, but it is not clear that an extended period of below-trend growth is unfolding. With most measures of spare capacity showing a lack of it, the ECB must still move forward with its plans to begin removing policy accommodation. Policy Choices: If the ECB downgrades its growth and inflation forecasts next month, delaying the end of the APP into 2019 is unlikely, as is altering the country weightings within the APP portfolio. More plausible options include pushing out forward guidance on future rate hikes, extending the maturity of the existing bond holdings, or introducing a new TLTRO to support lending. Impact On European Bonds & The Euro: The ECB is most likely to take a less hawkish slant in December, but will not signal any rapid move to begin hiking rates. This outcome will be bearish for the euro, but only neutral at best for overvalued European government bonds. Feature For the European Central Bank (ECB), the countdown is on to the December policy meeting, when a final decision will have to be made on the end of the Asset Purchase Program (APP). The central bank has been signaling throughout 2018 that net new APP bond purchases will stop at the end of the year, with a potential interest rate increase coming in September 2019 at the earliest. That decision on APP, however, will be conditional on the ECB remaining confident in its forecast that inflation will sustainably return to the target of "just below" 2%. Slumping European economic growth in 2018 means that the ECB's forecasts may prove to be too optimistic. This is especially true given the risks to growth and financial stability stemming from Italy's fiscal policy debate with the European Union, softening Chinese demand for European exports, and the uncertainties related to U.S. trade protectionism and the final U.K.-E.U. Brexit deal. Some pundits are even suggesting that the ECB may be forced to extend the APP program beyond December - or look for other ways to prevent a tightening of monetary conditions - even with headline inflation and wage growth having picked up across most countries. Against this increasingly muddled backdrop, what can the ECB credibly announce in December? In this Special Report, jointly published by BCA's Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the state of the euro area economy and then consider the ECB's next potential policy moves, with ramifications for European bond yields and the euro. Our conclusion is that there are a few policy tools available to the ECB in case of a prolonged slump in growth, without having to bring on the operational difficulties from extending the APP beyond December. Such a "dovish" shift would be bearish for the euro but neutral, at best, for European government bonds which remain deeply overvalued. ECB Policy Dilemma: Slowing Growth Vs. Accelerating Inflation At last month's monetary policy meeting, ECB President Mario Draghi noted that the slowing economy was merely returning to trend (or potential) growth from an unsustainably fast pace in 2017 that was fueled by strong export demand. Looking at the broad swath of euro area economic data, Draghi's relatively optimistic assessment is not far off the mark. The euro zone has seen a clear loss of economic growth momentum since the start of the year (Chart 1). The initial read on real GDP for the third quarter, released last week, showed a deceleration to a below-potential quarterly growth pace of 1.7%. The manufacturing purchasing managers index (PMI) has fallen from a peak of 61 in December 2017 to 52 in October, mirroring a -1% decline in the OECD's leading economic indicator for the region. Chart 1A European Growth Slump, Not Yet A Downtrend A European Growth Slump, Not Yet A Downtrend A European Growth Slump, Not Yet A Downtrend Yet not all the economic news has been that weak. Both consumer and business confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with above-trend real GDP growth (bottom two panels). Even though exports have weakened substantially from the booming pace in 2017 - largely due to China's slowing growth - the EC survey on firms' export order books remains at robust levels and overall export growth has rebounded of late (Chart 2). The current conditions component of the euro area ZEW index has also ticked higher (top panel), as has the bank credit impulse (bottom panel). Chart 2Not All The Economic News Is Bad Not All The Economic News Is Bad Not All The Economic News Is Bad The bigger issue for the ECB is that the recent cooling of growth comes at a time when, by almost all measures, there is little economic slack in the euro area. Capacity utilization is running at an 11-year high of 84%, while the output gap is effectively closed according to estimates from the IMF (Chart 3). Chart 3No Spare Capacity In Europe No Spare Capacity In Europe No Spare Capacity In Europe With that gap projected to turn positive in 2019, core inflation in the euro zone should be expected to drift higher. Yet core inflation now remains stuck around 1%, well below the headline inflation figure of 2% that has been heavily influenced by past increases in energy prices (bottom panel). The labor market is sending signals that the current period of low euro area inflation may be turning around. The unemployment rate for the entire region fell to a 10-year low of 8.1% in September, well below both the ECB's latest 2018 forecast and the OECD's estimate of the full employment NAIRU (Chart 4). This tightening labor market is a broad-based phenomenon across the euro area, with nearly 80% of countries in the region having an unemployment rate below NAIRU (middle panel).1 The last two times there was such a broad-based decline in unemployment in the region, in 2001-02 and 2006-07, a significant tightening of monetary policy was required as measured by a simple Taylor Rule. Chart 4Broad-Based Labor Market Strength Broad-Based Labor Market Strength Broad-Based Labor Market Strength Already, the tightening labor market is starting to put upward pressure on labor costs. The annual growth in wages & salaries accelerated to just over 2% in the second quarter of 2018. Similar to the fall in unemployment rates, the faster wage growth has also been widely seen throughout the region, with nearly three-quarters of euro area countries showing faster wage growth from one year ago (bottom panel). The mix of slowing growth momentum with some inflationary pressures can be seen in our ECB Monitor, which measures the cyclical pressures to tighten or ease monetary policy in the euro area. The Monitor had been signaling a need for tighter policy for most of the past two years, but has now fallen back to levels consistent with no change in policy (Chart 5). When breaking down the Monitor into its inflation and growth components, the latter has fallen the most. The inflation components remain in the "tight money required" zone above the zero line. Chart 5Our ECB Monitor Says 'Do Nothing' Our ECB Monitor Says 'Do Nothing' Our ECB Monitor Says 'Do Nothing' Looking across the balance of the euro area data, President Draghi's assessment that the recent economic weakness is not the beginning of a sustained move to below-trend growth is justified. Given the broad evidence pointing to a lack of excess capacity across the euro area economy, it will take a much bigger growth slump before the ECB can shift to a more dovish policy bias. The critical series to monitor will be business confidence, capital spending and export orders. All are at risk of downshifting due to slowing global trade activity and sluggish Chinese demand. BCA's China experts continue to have doubts that the Chinese government will undertake any typical initiatives to stimulate demand, like interest rate cuts or fiscal spending, given worries about high domestic debt levels. Without the impetus from strong Chinese import demand boosting euro area exports, the current tightness of euro area labor markets, and uptrend in wage growth, may be at risk of a reversal, as we discussed in a recent Special Report.2 Bottom Line: Economic growth in the euro area has lost momentum, but it is not clear that an extended period of below-trend growth is unfolding. With most measures of spare capacity showing a lack of it, the ECB must still move forward with its plans to begin removing policy accommodation. What Tools Are Available For The ECB? Net-net, when looking at the broad balance of growth and inflation data at the moment, there is not yet enough evidence to suggest that the ECB needs to back away from its current plans to end net new APP purchases in December. That does not mean that the ECB would not consider changes to its total mix of monetary policy measures. The ECB has treated the APP, which began in 2015, as a "deflation fighting tool" during a period when there was excess capacity and very low inflation in the euro area. That is no longer the case, so it will be difficult for the ECB Governing Council to argue in December that new APP purchases are still necessary. It would take a substantial downward adjustment to the ECB growth and inflation forecasts, with a subsequent upward revision to the expectations for the unemployment rate, for the ECB to reconsider the plans to stop new bond purchases at year-end. Yet the ECB has also made it clear that interest rate hikes will not happen soon after the APP purchases end. Going back over the entire 20-year history of the ECB, there have only been three tightening episodes through rate hikes: 1999-2000, 2003-07 and 2011. In all three cases, what prompted the rate hikes was a period of broad-based increases in euro zone inflation that followed a period of equally broad-based euro zone economic growth. This can be seen in Chart 6, which shows "diffusion indices", or breadth across countries, for euro area real GDP and inflation. A higher number means that a greater percentage of individual nations is experiencing faster growth or inflation, and vice versa. During those three previous tightening cycles, the diffusion indices all reached elevated levels for growth and, more importantly, inflation. With more countries enjoying the upturn, the ECB could be more confident in seeing the need for interest rate increases to cool off demand to prevent an inflation overshoot. Chart 6No Need For ECB Rate Hikes Anytime Soon No Need For ECB Rate Hikes Anytime Soon No Need For ECB Rate Hikes Anytime Soon At the moment, the diffusion indices are quite low, suggesting that few countries are witnessing accelerating growth or inflation. This means that there is no pressure for the ECB to move up its current dovish guidance to the markets about the timing of the first rate hike in late 2019. That also means that there is a risk that the ECB is forced to consider options for providing additional monetary accommodation if there was a large enough downgrade to its growth and inflation forecasts. If the ECB were to indeed lower its growth forecasts in December and consider additional easing options, there are only four plausible options at their disposal: 1) Extending the APP purchases beyond December, either at the current pace of €15bn/month or a slower pace between €5-10bn/month Extending the APP into 2019 is the least likely choice because the ECB is already close to some of the self-imposed constraints on its government bond holdings. The ECB has set a limit of owning no more than 33% of an individual country's allowable government bonds, with maturities of between 1-31 years. Right now, the ECB owns about 31% of all eligible German government debt (Chart 7), and would breach that 33% level sometime in the first half of 2019 if the current pace of buying was maintained without any increase in German bond issuance (i.e. smaller budget surpluses).3 A similar outcome would also occur for smaller bond markets, like the Netherlands and Finland (bottom panel). Chart 7ECB Will Hit Country Issuer Limits If Current APP Is Maintained ECB Will Hit Country Issuer Limits If Current APP Is Maintained ECB Will Hit Country Issuer Limits If Current APP Is Maintained Of course, this is a self-imposed rule by the ECB that can easily be changed. That already occurred back in 2016 when the ECB allowed the purchase of bonds below the deposit rate as part of its APP operations. This meant that the ECB would buy bonds with negative yields, essentially guaranteeing a loss assuming that the bonds were held to maturity. Yet given how much emphasis the ECB has placed on abiding by the issuer limits, we think the ECB would consider other policy choices before raising them. 2) Changing the composition of the APP portfolio Changing the mix of bonds within the APP portfolio is a more likely option, but even this has its limits. The ECB could choose to buy more corporate bonds or covered bonds, but those are less liquid markets where there is arguably more evidence that ECB buying has impacted market functionality. The ECB may be reluctant to take on more credit risk in its bond portfolio, as well. At the country level, the ECB could choose to move away from using its Capital Key weightings to determine the allocation of its bond purchases by country. In the current heated political atmosphere in Europe, however, with the populist Italian government in a very public battle with the E.U. over its 2019 budget, the ECB will not want to be seen as favoring any country more than another by buying more government bonds in places like Italy or Spain over Germany and France. That can already be seen in how bond purchases have been allocated in 2018, with purchases sticking closer to the Capital Key weightings in Italy and France from the larger weightings seen in 2017 (Charts 8 & 9). Chart 8The ECB Capital Key ... The ECB Capital Key... The ECB Capital Key... Chart 9... Is Not Always Adhered To ...Is Not Always Adhered Too ...Is Not Always Adhered Too A more likely reallocation of bond holdings could occur within each country by adjusting the maturities held within the ECB's portfolio. Following the template of the Fed's 2012 "Operation Twist", the ECB could aim to sell shorter-dated bonds in exchange for longer-maturity debt, thereby exacting a flattening influence on government yield curves. There is scope for that in Germany, where the weighted-average-maturity (WAM) of the ECB's bond holdings has decline by 18 months since peaking in late 2015 (Chart 10). Large declines in WAW have also occurred for Spanish, Italian and Portuguese bonds owned by the ECB, if policymakers were willing to take on more duration risk in the Periphery. Chart 10The ECB Has Room To Extend Its APP Maturities The ECB Has Room To Extend Its APP Maturities The ECB Has Room To Extend Its APP Maturities 3) Extend forward guidance on the first rate hike The easiest option for the ECB in the event of a downgrade of its growth/inflation projections is to simply extend the forward guidance on the timing of the first interest rate hike. Right now, our Months-to-Hike indicators, which measure the time until a full rate hike is discounted in the European Overnight Index Swap (OIS) curve, are discounting a hike of 10bps by November 2019 and a hike of 25bps by May 2020 (Chart 11). The ECB could easily signal that any rate hike, of any size, would not occur before the latter half of 2020 if an additional easing move was required. This would mostly likely result in lower bond yields and a weaker euro, all else equal, helping easy monetary conditions in the euro area. Chart 11Extending Forward Guidance Is An Option Extending Forward Guidance Is An Option Extending Forward Guidance Is An Option 4) Introduce a new Targeted Long-Term Lending Operation (TLTRO) One final intriguing option for an ECB policy ease would be the introduction of another TLTRO. The last such targeted lending program occurred in 2016, but the first wave of the much larger program that began in 2014 has already started to run off the ECB's balance sheet. This is the most effective way to get European banks to extend credit to borrowers at lower interest rates, since the banks would be able to fund that borrowing via the TLTRO at a rate lower than market rates. President Draghi did note last month that some members of the Governing Council brought up the idea of a new TLTRO at the ECB's policy meeting, and some well-known investment banks have recently discussed the implications of a new operation. In our view, a new TLTRO is the most effective way for the ECB to provide stimulus via lower private borrowing rates. It would also help offset any negative ramifications of the reduction of the ECB's balance sheet from the expiration of prior TLTROs. This would likely only happen, though, if there was evidence that the credit channel was impaired in the euro area. The previous TLTROs occurred after a period when banks were tightening credit standards, corporate borrowing rates and credit spreads were widening, European bank stocks were falling and European bank lending standards were becoming more restrictive (Chart 12). Chart 12A New TLTRO? Watch Lending Standards A New TLTRO? Watch Lending Standards A New TLTRO? Watch Lending Standards Today, bank stocks are falling and corporate bond yields/spreads are low but slowly rising, while European banks are actually easing lending standards according to the ECB's Q3 Bank Lending Survey. If the latter were to flip into the "tightening standards" zone, without any rebound in European bank shares or decline in corporate borrowing rates, the ECB could be tempted to go down the TLTRO route once again. Bottom Line: If the ECB downgrades its growth and inflation forecasts next month, delaying the end of the APP into 2019 is unlikely, as is altering the country weightings within the APP portfolio. More plausible options include pushing out forward guidance on future rate hikes, extending the maturity of the existing bond holdings, or introducing a new TLTRO to support lending. Likely ECB Options & Investment Implications In our view, the most realistic outcomes for the December ECB meeting can be boiled down to two decisions, conditional on how the ECB's economic forecasts are presented: 1) Unchanged growth & inflation forecasts: The ECB will signal the end of new APP bond purchases at the end of December, while maintaining the current forward guidance on rate hikes that no move will occur until at least September 2019. 2) Downgraded growth & inflation forecasts: The ECB will signal the end of new APP bond purchases at the end of December, but will also push out forward guidance on the first rate hike to at least sometime in mid-2020. In the latter scenario, the ECB could also consider two other options: extending maturities within its German bond holdings, or announcing a new TLTRO. We think that the ECB will wait to see how financial markets absorb the end of new APP buying before considering any move on maturity extension. At the same time, the ECB would signal that a TLTRO is a possibility if lending standards deteriorate and borrowing rates climb higher. While the ECB has talked a lot about how they will continue to reinvest the proceeds of maturing bonds in its portfolio, similar to what the Federal Reserve did after it ended its QE buying, the bigger impact on bond yields will come from a worsening of the supply/demand balance for European bonds. The ECB has been buying amounts greater than the entire net bond issuance of all euro area governments since the APP started in 2015, which has created a scarcity of risk-free sovereign debt for private investors. The result: extremely low bond yields, with a negative term premium (Chart 13). Reduced ECB buying will result in more bonds that have to be purchased by private investors, and a less negative term premium, going forward. Chart 13Bund Term Premium Unwind? Bund Term Premium Unwind? Bund Term Premium Unwind? How high euro area bond yields eventually go will then be determined by more traditional factors, like inflation expectations and the expected path of ECB rate hikes. Going back to the ECB's previous tightening cycles over its existence, actual rate hikes did now occur before inflation expectations - as measured by 5-year CPI swaps, 5-years forward - rose above 2% (Chart 14). Those inflation expectations are now 32bps below that level, and the ECB will not begin to shift to less dovish forward guidance unless the markets begin to discount more stable inflation close to the ECB's "near 2%" target. Chart 14Not Enough Inflation (Yet) To Justify Rate Hikes Not Enough Inflation (Yet) To Justify Rate Hikes Not Enough Inflation (Yet) To Justify Rate Hikes Dovish guidance on future ECB rate hikes will continue to widen the U.S.-Europe interest rate differentials that have helped weaken the euro versus the U.S. dollar in 2018 (Chart 15). This will continue to put downward pressure on EUR/USD cross, particularly with neutral momentum and positioning indicators suggesting that the euro is not yet oversold (bottom panel). Chart 15Likely ECB Actions Are Euro-Bearish Likely ECB Actions Are Euro-Bearish Likely ECB Actions Are Euro-Bearish Bottom Line: The ECB is most likely to take a less hawkish slant in December, but will not signal any rapid move to begin hiking rates. This outcome will be bearish for the euro, but only neutral at best for overvalued European government bonds. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Since not every country in the euro area is also part of the OECD, we could only use 14 of the 19 countries in the euro area in the indicator shown in the middle panel of Chart 5. 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?, dated October 6th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. 3 The ECB does allow the purchase of both federal government bonds, as well as the debt of government agencies and supranationals, as part of its APP. For our projections, we have assumed that of the €15bn in net new bonds that the ECB buys each month, 82% are debt issued by government-related entities (i.e. 18% goes to credit instruments like corporate bonds and covered bonds), with 10% of those government purchases going to supras. From that reduced number, we assume anywhere from 10-30% of purchases go to agencies, depending on the country. For the sake of simplicity, we also assume a pace of net government bond issuance in line with that seen over the past year, rather than make specific assumptions on changes in individual country budget deficits.

Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd Standing Out From The Crowd Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines Checking In On Our Rates View Checking In On Our Rates View It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 The Fundamentals Are Much Improved From 2015-16 The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Checking In On Our Rates View Checking In On Our Rates View Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve Stubbornly Staying Behind The Curve Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet The Fed Hasn't Gone Too Far Yet The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Two Steps Forward, One Step Back Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... An Economy Running Hot ... An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation ... Will Eventually Produce Inflation ... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Supply And Demand Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery A Steady, Job-Rich Recovery A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... As "Hidden" Unemployment Shrinks … As "Hidden" Unemployment Shrinks … We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise ... Wages Should Rise ... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet No Sign Of Overheating Yet No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1

Highlights Duration: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Yield Curve: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Feature If investors were already worried about the impact of restrictive Fed policy on credit spreads and equities, the minutes from September's FOMC meeting - released last Wednesday - did nothing to calm their nerves. The minutes revealed that "a few participants expected that policy would need to become modestly restrictive for a time" while an additional "number" of participants "judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level." There is a small distinction between the "few" participants who expect that a fed funds rate above the estimated longer-run neutral level of 3% will be necessary because restrictive monetary policy will be warranted and the "number" of participants who think that the fed funds rate will move above 3% without policy turning restrictive. However, the main takeaway for investors should be that a large portion of the committee expects that rate hikes will continue until the fed funds rate is at least above 3%. In last week's report we explored the risk that higher yields lead to an excessive tightening of financial conditions and actually sow the seeds of their own decline.1 But we do not view that as the greatest threat to our recommended below-benchmark portfolio duration stance. The biggest risk to that view comes from the ongoing divergence between strong U.S. and weak foreign economic growth. No Contagion... Yet Chart 1 shows that, since 1993, every time our Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed. But while the Global (ex. U.S.) LEI has now been below zero for nine consecutive months, there is so far no evidence of contagion into the United States. The resilience of the U.S. economy probably explains why the September FOMC minutes only briefly mentioned the risk from weak foreign growth. Chart 1U.S. And Foreign Growth Continue To Diverge U.S. And Foreign Growth Continue To Diverge U.S. And Foreign Growth Continue To Diverge From the minutes:2 The divergence between domestic and foreign economic growth prospects and monetary policies was cited as presenting a downside risk because of the potential for further strengthening of the U.S. dollar... But: Participants generally agreed that risks to the outlook appeared roughly balanced. The concern is that, much like in the 2014-16 period, the divergence in growth between the U.S. and the rest of the world puts so much upward pressure on the dollar that it eventually drags U.S. growth and bond yields lower. But despite this year's 4.6% appreciation in the trade-weighted dollar, we have yet to see any impact on our Fed Monitor and Treasury yields remain in an uptrend (Chart 2). This suggests that we have not yet reached peak divergence between U.S. and foreign growth. Further divergence and dollar strength is necessary before the U.S. economy is negatively impacted. Chart 2More $ Strength Required More $ Strength Required More $ Strength Required The reason why the dollar's recent appreciation has not yet exerted a discernible impact on the U.S. economy might be because overall global GDP growth is on a more solid footing than it was in 2014-16 (Chart 3). The IMF forecasts that global GDP growth will be 3.7% in 2018 and 2019, compared to 3.5% in 2015. Meanwhile, the moderation in Eurozone growth represents a decline from lofty 2017 GDP growth of 2.4%. Even in emerging markets, where the global growth slowdown is most apparent, the IMF is still forecasting GDP growth of 4.7% for both 2018 and 2019, a far cry from the 4.3% seen in 2015 (Chart 3, bottom panel). Chart 3Global Growth Stronger Than 2014-16 Global Growth Stronger Than 2014-16 Global Growth Stronger Than 2014-16 Of course, IMF forecasts can always change, and they likely will be revised lower if current trends continue. However, the key point for bond investors is that the global economy is in much better shape than it was between 2014 and 2016. This means that non-U.S. growth needs to see further significant weakness before the uptrend in U.S. Treasury yields is threatened. Bottom Line: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Can Uncertainty Steepen The Yield Curve? The yield curve has steepened somewhat during the past few weeks, the result of much higher yields at the long-end of the curve and short-end yields that have been roughly unchanged. We think Fed communication has been an important catalyst for this curve action. Specifically, the Fed's deliberate attempt to introduce uncertainty around its estimates of the neutral fed funds rate.3 Bond investors are finally getting the message that the Fed's median forecast of a 3% longer-run fed funds rate is not written in stone. Depending on the economic outlook, the funds rate could peak for the cycle at a level that is well above or below 3%. Given the recent spate of strong U.S. economic data, the market is starting to discount a peak that is above 3%, no matter what median forecast appears in the Fed's dots. This raises the question of whether a further un-anchoring of long-dated yields could occur. Is it possible that the yield curve will continue to steepen, even with the Fed lifting short rates at a gradual pace of 25 basis points per quarter? Below, we review a few different macro drivers of the yield curve and conclude that neither a large steepening nor large flattening is likely during the next 6-12 months. Nominal GDP Growth One useful rule-of-thumb for when monetary policy turns restrictive is when the 10-year Treasury yield exceeds the rate of growth in nominal GDP. In the past, a 10-year yield above the rate of growth in nominal GDP has coincided with downward pressure on core inflation (Chart 4). With that in mind, we note that nominal GDP has grown by 5.44% during the past year, by 3.98% (annualized) during the past two years and by 3.85% (annualized) during the past three years. Chart 410-Year Yield & Nominal GDP 10-Year Yield & Nominal GDP 10-Year Yield & Nominal GDP We discount the recent 5.44% growth rate because it was largely fueled by fiscal thrust that will fade in the coming quarters. This leaves us with a recent trend of 3.85% - 4% in nominal GDP growth. Even with no further deterioration in growth as the cycle matures, this puts an approximate cap on how high long-dated yields can rise before policy becomes restrictive and the cycle starts to turn. With the 10-year Treasury yield already at 3.19%, it can rise by between 66 bps and 81 bps before it reaches that range. If that adjustment were to occur very quickly, then the yield curve would steepen sharply and then re-flatten as the Fed lifted rates to catch up with the long end. Alternatively, if that adjustment were to occur over a period of 6-9 months, with the Fed hiking at a pace of 25 bps per quarter, the slope of the yield curve would be roughly unchanged. Wage Growth While nominal GDP growth is useful for thinking about long-maturity yields, wage growth correlates quite strongly with the slope of the yield curve itself. Specifically, rapid wage gains tend to coincide with curve flattening, and vice-versa. In fact, a typical cyclical pattern is that first the yield curve flattens and then wage growth accelerates to catch up with the curve (Chart 5). It would be highly unusual for the yield curve to steepen significantly while wage growth is rising, which it finally appears to be doing. Chart 5Higher Wage Growth = Flatter Curve Higher Wage Growth = Flatter Curve Higher Wage Growth = Flatter Curve We cannot completely rule out the possibility that stronger productivity growth actually causes unit labor costs to decelerate even as "top line" wage pressures mount. Unit labor costs are essentially the ratio of wages (compensation per hour) to productivity (output-per-hour), and the bottom panel of Chart 5 shows that a deceleration in unit labor costs could cause the yield curve to steepen. However, we note that there is not much precedent for strong productivity growth overwhelming an acceleration in wages, causing unit labor costs to diverge from other wage measures. For example, even as productivity growth strengthened in the 1990s, unit labor costs continued to rise alongside other measures of wage growth. Inflation Expectations We have frequently noted that inflation expectations embedded in long-dated Treasury yields remain too low compared to levels that are consistent with inflation being well-anchored around the Fed's 2% target. It stands to reason that long-maturity TIPS breakeven inflation rates could steepen the yield curve as they adjust higher. However, the 10-year TIPS breakeven inflation rate is currently 2.11%, only slightly below the range of 2.3% to 2.5% that has historically been consistent with well-anchored inflation expectations (Chart 6). In other words, the upside in long-dated breakevens is now fairly limited. In contrast, the 2-year TIPS breakeven inflation rate stands at only 1.70%, still considerably below "well-anchored" levels (Chart 6, bottom panel). Chart 6More Upside In Short-Dated Breakevens More Upside In Short-Dated Breakevens More Upside In Short-Dated Breakevens Further, since the financial crisis, breakevens at both the short- and long-ends of the curve have been driven by trends in the actual inflation data (Chart 7). If it is rising realized inflation that has driven both the 2-year and 10-year TIPS breakeven inflation rates higher this cycle, and the 2-year rate is further away from target than the 10-year rate, then it stands to reason that inflation expectations are more likely to exert flattening pressure on the nominal yield curve than steepening pressure. Chart 7Realized Inflation Is Driving Expectations Realized Inflation Is Driving Expectations Realized Inflation Is Driving Expectations Rate Volatility & The Term Premium One final macro driver that could steepen the yield curve would be a spike in interest rate volatility and an increase in the term premium at the long-end of the curve. Our prior research has shown that implied interest rate volatility is linked to uncertainty about the macro environment, and Chart 8 shows that the MOVE index of implied interest rate volatility has tended to track the dispersion of individual forecasts of 3-month T-bill rates and GDP growth. In this context, it should not be surprising that implied volatility fell to very low levels when interest rates were pinned at zero and not expected to move for an extended period. Chart 8Macro Uncertainty & Rate Volatility Macro Uncertainty & Rate Volatility Macro Uncertainty & Rate Volatility But, as was mentioned above, the Fed has been trying scale back its forward guidance and inject some uncertainty into the market. Indeed, we think this is one reason why the yield curve steepened and rate volatility increased during the past few weeks. Taking a broader view, we also observe that, historically, macro uncertainty and implied interest rate volatility have tended to fall when the Fed is hiking rates, only spiking once monetary policy becomes restrictive and the economic recovery is threatened. The yield curve is typically inverted by that point. This leaves us to conclude that some further increase in interest rate volatility from exceptionally low levels is possible, but a large spike is unlikely until monetary policy becomes restrictive. Investment Implications A survey of the macro drivers of the yield curve leaves us to conclude that the most likely outcome for the next 6-12 months is that the slope of the curve remains close to its current level, meaning that the curve undergoes a roughly parallel upward shift as the Fed continues to lift rates. However, if nominal GDP growth fails to decelerate from its current 5.44% clip, it is possible that the yield curve steepens first and then flattens as the Fed lifts rates more quickly to catch up. This is not the most likely outcome, but rather a risk to our base case scenario. The final piece of the puzzle is the observation that curve steepener trades continue to look attractively priced. Our current recommendation is to favor the 7-year bullet over a duration-matched barbell consisting of the 1-year and 20-year notes. This trade offers a spread of +8 bps above the reading from our fair value model (Chart 9). Or alternatively, our model shows that the 1/7/20 butterfly spread is currently priced for 29 bps of 1/20 curve flattening during the next six months (Chart 9, bottom panel). Chart 9Curve Steepeners Are Still Attractive Curve Steepeners Are Still Attractive Curve Steepeners Are Still Attractive That much curve flattening is highly unlikely in the current macro environment, and we continue to recommend curve steepener trades to profit from an unchanged yield curve during the next six months. Bottom Line: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1Please see U.S. Bond Strategy Weekly Report, "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 2https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180926.pdf 3Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights European and Japanese wages have firmed significantly, suggesting upside to inflation in these economies. However, the gain in European wages will soon reverse, as the slowdown in global trade percolates through the European economy. The ECB will not raise rates sooner or faster than currently discounted in markets, and German Bunds remain attractive in currency hedged terms. Japanese wage growth seems more sustainable but Japanese inflation expectations remain anchored to the downside, and Japan will suffer from a fiscal shock when the consumption tax is increased next October. Japan's YCC policy will remain in place for at least another 18 months, and fixed-income investors should continue to overweight JGBs in currency-hedged fixed income portfolios. Feature The pick-up in wage growth this summer in the euro area and Japan has been an interesting development. It raises the risk that inflation in these two economies is about to hit an inflection point. Since growth has returned to these two regions, if inflation were to join the party, the European Central Bank and the Bank of Japan would finally be able to follow in the Federal Reserve's footsteps and begin increasing rates sooner rather than later. This week we explore whether or not inflationary pressures are building in Europe and Japan, and whether or not the expected policy path of the ECB and the BoJ needs to be re-assessed. While cyclical pressures are growing, clouds above the global economy - the EM space in particular - suggest that the policy path currently anticipated by money markets is just right, and no glaring mis-pricings are evident. Euro Area: A Dawn Is Not A Sunrise The Necessary Condition For Inflation Is Here... There is no denying that we have seen massive improvements in the euro area economy. In fact, we would argue that the euro area has finally hit a stage where the necessary condition for a re-emergence of inflation has been met: Economic slack has vanished. There seems to be little spare capacity in the aggregate euro area economy. Today the OECD measure for the output gap stands at +0.5% of GDP. Additionally, a basic approach comparing the level of industrial production to a simple statistical filter further confirms this assessment, showing that production stands 2% above trend (Chart 1). The capacity utilization measure published by the European Commission goes one step further, showing that utilization is at its highest level since 2008. This represents a very significant change from the days of 2011-2015, when capacity utilization stood below the average that prevailed from the time of the euro's introduction (Chart 2). Chart 1No More Slack In Europe No More Slack In Europe No More Slack In Europe Chart 2Capacity Utilization Is At Previous Cycle Peaks Capacity Utilization Is At Previous Cycle Peaks Capacity Utilization Is At Previous Cycle Peaks The labor market has been a particular source of concern for euro area watchers. After all, how can an economy generate any domestic inflationary pressures if wages remain depressed? On that front too, there is plenty to rejoice about. The gap between the euro area's unemployment rate and the OECD's estimate of the non-accelerating rate of unemployment (NAIRU) has nearly fully disappeared. Historically, such an occurrence has been associated with a rise in European core inflation (Chart 3). In fact, the ECB's labor underutilization survey is now at its lowest level in 10 years. Moreover, in its various business conditions surveys, the European Commission asks firms whether labor is a factor limiting production. With the exception of Italy, the number of firms reporting that labor shortages are a problem in most of the major economies stands at or near record highs (Chart 4). This confirms the simple impression provided by the gap between the unemployment rate and NAIRU that the labor market is beginning to create generalized inflationary and wage pressures. Chart 3Diminishing Labor Market Slack Leads##br## To Growing Inflationary Pressures Diminishing Labor Market Slack Leads To Growing Inflationary Pressures Diminishing Labor Market Slack Leads To Growing Inflationary Pressures Chart 4Labor Shortages In ##br##The Euro Area Labor Shortages In The Euro Area Labor Shortages In The Euro Area ...But The Sufficient Conditions Remain Murkier While the tight labor market suggests that wages have cyclical upside, is it even true that higher wages do lead to higher inflation in the euro area? The answer is yes. Chart 5 shows that euro area wages tend to lead core CPI by approximately three quarters, with an explanatory power of nearly 87%. This makes sense. Higher wages increase the cost of production for businesses, which results in cost-push inflation. This is even more true if wages rise in real terms, which boosts household's income and supports consumption. Thus, it is likely that the recent spike in wages will lead to higher core inflation. Despite this positive backdrop, some key cyclical worries remain. First, our CPI diffusion index for the euro area, measuring the breadth of inflation increases within the subcomponents of the CPI, is in free-fall. Historically, this has been a worrying sign for core inflation, and for both nominal and real wages (Chart 6). Chart 5In Europe, Wages ##br##Lead Core CPI In Europe, Wages Lead Core CPI In Europe, Wages Lead Core CPI Chart 6But CPI Diffusion Index Suggests Real Wages ##br##And Core CPI Could Hit A Speed Bump But CPI Diffusion Index Suggests Real Wages And Core CPI Could Hit A Speed Bump But CPI Diffusion Index Suggests Real Wages And Core CPI Could Hit A Speed Bump The bigger risk originates from outside the euro area. We have shown in the past that EM shocks can have a disproportionate impact on European economic activity.1 This link seems to run deeper than we had originally realized. As Chart 7 shows, euro area nominal and real wages tend to follow the trend in European exports to EM and China. The logical conclusion is that export shocks end up affecting the whole economy by depressing profits, capex and the willingness of firms to provide wage increases to their employees. This also ends up reverberating into consumption as both nominal and, more importantly, real wages suffer. Today, weakening exports to EM and China suggest that European wages may soon roll over. This would take the wind out of price inflation as well, since wages lead core CPI by roughly three quarters. BCA's Foreign Exchange Strategy service as well as our Emerging Market Strategy sister publication have already highlighted that EM economies are likely to slow further in the coming quarters as China works to de-lever - a process which has already begun (Chart 8).2 Thus, the negative impact of EM on European growth and wages is likely only to grow over the coming quarters. The euro area leading economic indicator (LEI) has already picked up on these dynamics. The deterioration in the LEI suggests that real wages are likely to soon suffer, which will further dent euro area consumption and weigh on core inflation (Chart 9). Chart 7Exports To EM Are The Culprit##br## Behind This Speed Bump Exports To EM Are The Culprit Behind This Speed Bump Exports To EM Are The Culprit Behind This Speed Bump Chart 8Limited Upside Ahead##br## In Chinese Growth Limited Upside Ahead in Chinese Growth Limited Upside Ahead in Chinese Growth Chart 9Euro Area LEI Confirms##br## The Message From Exports Euro Area LEI Confirms The Message From Exports Euro Area LEI Confirms The Message From Exports Adding up those various message we conclude that while we could soon see some upside in inflation via a pass-through of the recent pick-up in wages, the upside is likely to prove transitory as the euro area economy will soon feel the deflationary impact of the slowdown in EM economic activity. What Will The ECB Do? The ECB will end its asset purchase program at the end of this year. Money markets are currently pricing in a full 25-basis-point hike in interest rates by March 2020. However, various formulations of the Taylor Rule suggest that euro area interest rates should already be higher than they currently are (Chart 10). What are interest rates likely to really do in relation to this date? Despite these hawkish Taylor Rule estimates, we think the ECB is likely to wait and see. As we highlighted above, the slack in the euro area economy is dissipating, and therefore inflationary pressures are bound to build up. However, the slowdown in EM that is reverberating through global trade will weigh on inflation over the coming six months. Additionally, we need to monitor developments in shadow policy rates.3 After the Fed began tapering its asset purchases in 2014, the U.S. shadow rate increased by roughly 300 basis points. While the actual fed funds rate was not raised until the end of 2015, the implied tightening from the rise in the shadow rate was enough to cause both U.S. and non-U.S. growth to slow sharply in 2015. Since bottoming in November 2016, the ECB's shadow rate has increased by 450 basis points. Even if European monetary conditions remain accommodative, this is a large and sudden shock to absorb - one that goes a long way in explaining the sudden contraction in the euro area credit impulse (Chart 11). Chart 10Does Europe Really Need Higher Rates? Does Europe Really Need Higher Rates? Does Europe Really Need Higher Rates? Chart 11Large Tightening In Euro Area Shadow Rate Large Tightening In Euro Area Shadow Rate Large Tightening In Euro Area Shadow Rate Ultimately, while the reduction in the euro area economic slack is real, the aforementioned dynamics are worrisome. Hence, we do not think that the ECB will want to prematurely kill off the recovery. Memories of the policy mistake of 2010, when the ECB raised rates in a too-weak economy, are still very much alive on the ECB's Governing Council. This means that a small first hike of less than 25 basis points in late 2019 or early 2020 seems appropriate, as there should be more convincing evidence by then that the economy can tolerate higher interest rates. Hence, there does not seem to currently be any mis-pricing in the European interest rate curve since investors are correctly pricing in a full 25-basis points of hikes from the ECB by March 2020. Investment Implications We continue to recommend U.S. investors hold European bonds while hedging the currency exposure back into U.S. dollar. A hedged 10-year Bund currently yields 3.66%, compared to 3.2% for a 10-year Treasury note. The picture above does not suggest that Bund yields will have enough upside to generate the capital losses needed to offset this yield pick-up, especially as Treasury prices suffer greater potential downside. This also means that once hedging costs are taken into account, European fixed-income investors are better off staying at home than playing in the U.S. government bond market. The impact for EUR/USD is more complex. The U.S. Overnight Index Swap (OIS) curve is currently pricing in roughly three rate hikes by the Fed over the next 12 months. BCA think that there could be even more U.S. rate hikes as the Fed continues to follow a 25 basis-points-per-quarter pace. Thus, we do not see the spread between U.S. and euro area interest rates narrowing in a more bullish direction for the euro Moreover, currencies trade on more than just interest rate differentials. The dollar has historically responded favorably to slowing EM growth. Moreover, as we highlighted three weeks ago, since the U.S. balance of payments is currently in surplus, this means that the U.S. is sucking in liquidity from the rest of the world.4 This is another way of saying that the world is buying more dollars than the U.S. is supplying. As a result, the dollar could continue to experience upside versus the euro over this period from factors beyond simple rate differentials. Bottom Line: The euro area economic slack has greatly dissipated and the medium term outlook for inflation is improving. Moreover, the recent pick-up in euro area wages suggest that core CPI could also pick up in the coming months. However, this increase in inflation is likely to prove temporary. Before inflation can increase durably, Europe will first have to digest the deflationary impact of slowing EM economies and global trade. This means that the ECB is likely to proceed with policy normalization very cautiously. The current pricing of 25 basis points of hikes by March 2020 is sensible. Hence, investors should continue to overweight Bunds hedged back into dollars in global fixed income portfolios. Moreover, EUR/USD could experience additional weaknesses on a 12-month basis. Japan: Fragile Progress, But Not Enough This past June, Japanese wage growth hit rates not seen in 21 years. This is enough to begin wondering if Japan is finally escaping its two-decades-long deflationary trap. After all, as Chart 12 shows, Japanese wages are a slow but nonetheless leading indicator of core inflation. Giving even more comfort to forecasts of higher Japanese inflation is the fact that, after falling continuously from the bubble peak in the early 1990s until Q1 2017, Japanese land prices have been slowly but surely increasing. Inflationary pressures in Japan are building up because the economy is at full employment. According to the BoJ, the output gap stands at +1.9% and has been positive for two years. The unemployment rate is at a stunningly low level of 2.4%, and the active job opening-to-applicant ratio stands at a four-decade high. The implications of this backdrop are evident. Chart 13 shows the demand/supply condition component of the Tankan survey of Japanese businesses, both in the manufacturing and non-manufacturing sectors. It has historically been a good explanatory variable for wage developments in Japan, and currently points to additional strength. Chart 12Rising Japanese Wages Should Boost Core Inflation Rising Japanese Wages Should Boost Core Inflation Rising Japanese Wages Should Boost Core Inflation Chart 13Capacity Pressures Are Lifting Japanese Wages Capacity Pressures Are Lifting Japanese Wages Capacity Pressures Are Lifting Japanese Wages Despite these positive developments, there remain some nagging worries. For one, the pick-up in wages seems strange in an economy where total hours worked are not rising (Chart 14). Moreover, Japanese households are currently increasing their savings ratio, which means that while they might be earning more, they are keeping this money in their bank accounts rather than spending it (Chart 14, bottom panel). As a result, there has been a limited pass-through of the recent wage acceleration into higher consumption. Additionally, like in Europe, the Japanese economy is at risk from foreign shocks. While the domestic economy seems robust, foreign machinery orders have been weakening. Industrial production has followed this path, decelerating sharply (Chart 15). Historically, Japanese inflation is very sensitive to the level of broader economic activity, so this weakening trend in industrial activity points to limited upside for overall inflation. Chart 14Weird Dynamics In Japan Weird Dynamics In Japan Weird Dynamics In Japan Chart 15Japan: The Domestic Front Is Healthy, The Foreign One Is Not Japan: The Domestic Front Is Healthy, The Foreign One Is Not Japan: The Domestic Front Is Healthy, The Foreign One Is Not The biggest problem faced by the BoJ, however, remains the weakness in inflation expectations. In the eyes of the Japanese central bank, the reason why Japanese realized inflation and wage growth have remained tepid is because decades of low inflation have created embedded expectations among the Japanese to not expect rising prices. Today, Japanese inflation expectations are once again weakening, a common occurrence when global growth slows (Chart 16). Additionally, Japan could hit a fiscal cliff of sorts next year. In October 2019, the consumption tax will increase from 8% to 10%. The last such increase - a three-percentage point hike in 2014 - caused a major slowdown in economic activity that had a deep deflationary impact. While the increase this time around is smaller and the Japanese economy is stronger than in 2014-2015, it remains to be seen how the country handles the shock of a fiscal tightening via a higher sales tax, especially if exports to EM remain on their downward path. The BoJ is likely to be very cognizant of this risk. Currently, the low level of inflation means that the real BoJ policy rate is in line with that of the U.S., a much stronger economy (Chart 17, top panel). Since Japan still faces a fiscal cliff next year and inflation expectations have not yet been unmoored to the upside, the current increase in wages is not enough to push the BoJ to abandon its Yield Curve Control (YCC) policy. What about QQE? The low shadow rate means that the BoJ does not need to buy assets anymore (Chart 17, bottom panel). Yet, the problem for Japan is that QQE possesses a strong signaling component. Ending this program is likely to cause markets to price in the end of YCC, which would drive nominal rates higher and thus result in both higher real rates and a significant tightening in monetary policy. As a result, we expect QQE to remain in place so that YCC will stay credible. However, the program is likely to have a slower pace of buying than before and will be too small to fully absorb the new issuances of JGBs by the MoF (Chart 18). Chart 16The BoJ's ##br##Number 1 Problem The BoJ's Number 1 Problem The BoJ's Number 1 Problem Chart 17The Signaling Effect Of QQE Is##br## Still Needed Because Of YCC... The Signaling Effect Of QQE Is Still Needed Because Of YCC... The Signaling Effect Of QQE Is Still Needed Because Of YCC... Chart 18...But QQE Doesn't Need To Be ##br##Quite As Large Anymore ...But QQE Doesn't Need To Be Quite As Large Anymore ...But QQE Doesn't Need To Be Quite As Large Anymore In terms of signposts that would signal to us to begin betting on an end to YCC, we continue to target three things that must ALL happen in unison, highlighted by BCA's Chief Global Fixed Income Strategist, Rob Robis, in February:5 USD/JPY rises at least to the 115-120 range; Japanese core CPI and nominal wage inflation both rise above 1.5%; 10-year JGB yields reaching an overvalued extreme, based on a model that includes potential GDP, BoJ purchases and the level of 10-year Treasury yields. So far, none of these conditions has been met. In fact, the slowdown in global trade and EM activity could even threaten the current improvement witnessed in wages. As a result, we expect all three of these developments to only happen in 2020, leaving Japanese yields with very limited upside. Investment Implications Japanese fixed-income investors continue to be subsidized to remain at home and avoid U.S. Treasuries. Because short rates in Japan are so low, the yield on 10-year U.S. Treasuries hedged into yen yield is 0.05%, less than the 0.16% yield on 10-year JGBs. At the same time, U.S. fixed income investors are incentivized to buy JGBs and hedge the currency exposure into dollars. Additionally, with the BoJ unlikely to abandon its YCC program for potentially two more years, JGBs with up to 10-year maturities are unlikely to suffer capital losses. Largely for this reason, BCA's Global Fixed Income Strategy's recommended model bond portfolio, maintains a large overweight position in JGBs, but only for maturities less than 10 years as the BoJ's YCC program is not focused on yields beyond the 10-year point. Regarding the yen, the outlooks is treacherous. On one hand, a strong USD implies a weaker yen. So do higher 10-year Treasury yields, especially if JGB yields possess little upside. On the other hand, weakness in the EM space tends to result in a stronger yen as carry trades get unwound. Due to these bifurcated risks, we do not recommend buying the yen against the dollar. However, we think that at current levels the yen remains an attractive play against the euro and against the Australian dollar, especially on a six- to nine-month basis. Bottom Line: Japanese wages have enjoyed significant upside, but Japanese inflation expectations remain moribund. Moreover, Japan is likely to experience a negative fiscal shock next year as the consumption tax will once again be increased. These two risks, in addition with slowing global growth, mean that the BoJ is unlikely to abandon YCC until well into 2020. As a result, investors should continue to overweight JGBs with maturities of less than 10-years hedged back into U.S. dollars in a global fixed income portfolio. USD/JPY should enjoy further upside on a 12-month basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "ECB: All About China", dated April 7, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com and Emerging Markets Strategy Special Report, titled "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 3 The shadow rate is a measure of the impact of the various unorthodox policy initiatives implemented by central banks in the wake of the great financial crisis. It tries to express the effect of those measures in terms of the implied levels of policy rates that would have needed to prevail for the economy to generate the same performance if asset purchases had not been implemented. 4 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergences Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 5 Please see Global Fixed Income Strategy Special Report, titled "What Would It Take For The Bank Of Japan To Raise Its Yield Target", dated February 13, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot China Saves A Lot China Saves A Lot Chart 19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIMarket Outlook: Bonds 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIIMarket Outlook: Currencies 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IVMarket Outlook: Commodities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades