Manufacturing

Highlights Analyses on Indonesia and South Africa are available below. The slowdown in Chinese domestic demand has been the main culprit behind the global trade contraction - not the U.S.-China trade confrontation. China’s economy is not reliant on exports to the U.S. and there has been little damage to Chinese total exports. In contrast, Chinese imports have been contracting, dampening global trade. A recovery in the former is contingent on credit stimulus. Feature Chart I-1Chinese Imports Are Contracting Yet U.S. Ones Are Not With odds of a potential trade deal between the U.S. and China rising, the question now becomes whether an imminent acceleration in global trade will occur, sparking a rally in EM risk assets and currencies. We believe the trade confrontation between the U.S. and China has not been the main culprit behind the global trade contraction and manufacturing recession. The latter has primarily been due to a slowdown in Chinese domestic demand. Chart I-1 illustrates that Chinese imports for domestic consumption (excluding processing trade) are shrinking at 6% while U.S. total imports are still growing at 2% from a year ago. Consequently, an improvement in the global business cycle due to a potential trade agreement between the U.S. and China will be limited. Provided the global business cycle is the main factor driving EM risk assets and currencies, there is no sufficient reason to turn bullish on EM at the current juncture. Origin Of The Global Trade Slowdown Tariffs have mainly affected global growth indirectly (via dampening business confidence) rather than directly – by derailing Chinese exports to the U.S. or by affecting American consumer spending. First, U.S. household spending is still reasonably robust, and U.S. imports from the rest of the world have slowed but have not contracted (Chart I-2). Hence, the trade confrontation has not derailed U.S. household spending, and the latter’s impact on global trade has been mildly positive rather than negative. An improvement in the global business cycle due to a potential trade agreement between the U.S. and China will be limited. Second, Chinese exports have been more resilient than those of other Asian economies (Chart I-3). If the tariffs on Chinese exports to the U.S. were the main cause of the global trade slump, Chinese exports would be shrinking the most. Yet Chinese exports are not contracting – their growth rate is close to zero while Korean and Japanese exports have been plummeting (Chart I-3). Chart I-2U.S. Consumer Spending And Imports Have Not Been A Drag On Global Trade Chart I-3Exports In China Are Faring Better Than Those In Japan And Korea   While China’s shipments to the U.S. have certainly plunged, there is both anecdotal and empirical evidence that mainland-produced goods have been making their way to the U.S. via Taiwan, Vietnam and other economies (Chart I-4). This is why Chinese aggregate exports are not contracting. Third, Chinese exports are doing better than imports (Chart I-5). This tells us that the underlying reason for the slowdown both in China and globally is not tariffs, but rather the weakness in Chinese domestic demand. Chart I-4China's Exports To U.S. Have Been Re-Routed Via Rest Of Asia Chart I-5Chinese Imports Are Worse Than Its Exports   Importantly, ongoing contraction in Chinese imports excluding processing trade (i.e., excluding imports of inputs that are assembled and then re-exported) is a clear indication of a slump in Chinese domestic demand (please refer to Chart I-1 on page 1). Capital outlays in general and construction activity in particular remain very weak (Chart I-6). This is consistent with shrinking import volumes of capital goods, base metals, chemicals and lumber (Chart I-7). Chart I-6China: Capex Is In Doldrums Chart I-7China: Capex-Exposed Imports Are Shrinking   Chart I-8China's Economy Is Not Reliant On Exports To The U.S. Finally, Chart I-8 shows that Chinese exports to the U.S. before the commencement of the trade war represented less than 4% of Chinese GDP. In contrast, capital spending in China is 42% of GDP. Hence, China’s economy is not reliant on exports to the U.S. This is why in our research and strategy we emphasize the mainland’s money/credit cycle – which leads capital spending – much more than its exports. To be clear, we are not implying that the U.S.-China trade confrontation has had no bearing on global growth. It has certainly affected business and consumer sentiment in China and hurt confidence among multinational companies. Hence, a trade deal could boost sentiment among these segments, leading to some improvement in their spending. Nevertheless, odds are that businesspeople in China and multinational CEOs around the world will realize that we are witnessing a secular rise in the U.S.-China confrontation, and that any trade deal will be temporary. The basis is that the genuine interests of the U.S. go against China’s national interests, since the U.S. has an interest in preventing the formation of a regional empire that can then challenge it for global supremacy. Conversely, whatever is in the long-term interests of China will not be acceptable for the U.S., particularly China’s rapid military and technological advancement. As such, global CEOs may see through a trade deal and any improvement in their confidence will likely be muted. In fact, if a China-U.S. trade détente leads Chinese authorities to resort to less stimulus going forward, odds are that China’s domestic demand revival will be delayed. Hence, the positive boost to global trade will not be substantial. The underlying reason for the slowdown both in China and globally is not tariffs, but rather the weakness in Chinese domestic demand. In such a case, global manufacturing and trade contraction will likely last longer than financial markets are presently pricing in. Asset prices will need to be reset in this scenario before a new cyclical rally begins. Bottom Line: The trade confrontation has not been the main reason behind the global trade slowdown. Consequently, its temporary resolution may not be enough to produce a cyclical recovery in global trade. Given financial markets have already bounced back in recent weeks, they may follow a “buy the rumor, sell the news” pattern regarding the trade deal. Investors should continue to underweight EM equities, sovereign credit and currencies within respective global portfolios. In absolute term, risks to EM assets and currencies are still tilted to the downside too. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Relapsing Growth Risks Foreign Outflows Indonesian stocks and the rupiah have been benefiting from falling U.S. interest rate expectations. This has been occurring even though domestic fundamentals, namely economic growth and the outlook for corporate profits, have been deteriorating. The Indonesian economy is undergoing a sharp slowdown: The private credit impulse is declining (Chart II-1, top panel). Retail sales volume of various goods are heading south (Chart II-1, middle panel). Mirroring the weakness in investment expenditures, capital goods imports are shrinking (Chart II-1, bottom panel). Passenger car sales are shrinking and sales of other types of vehicles have stalled. The real estate sector has entered a weak spot as well. House prices are only growing at 2% in nominal local currency terms according to data from the central bank. Growth in rail freight transport has stalled and the manufacturing PMI has dipped below the critical 50 level (Chart II-2, top and middle panels). Domestic cement consumption is contracting (Chart II-2, bottom panel). Chart II-1Indonesia: Domestic Demand Is Slumping Chart II-2Indonesia: Business Activity Is Anemic Finally, exports are dwindling at an annual rate of -8% from a year ago. Chart II-3Borrowing Costs Are Elevated Relative To Nominal Income Growth This growth deceleration is due to the ongoing contraction in exports, slowing domestic loan growth and somewhat conservative fiscal policy. These factors have altogether hit nominal incomes and hurt spending. Meanwhile, Indonesia’s lending rates remain elevated and well above nominal growth (Chart II-3). Such a gap between nominal income growth and borrowing costs is exerting deflationary pressures on the Indonesian economy. Consistent with worsening growth dynamics, non-financial stocks have been struggling and small cap stocks have been in a bear market since 2013 (Chart II-4). The basis is poor and deteriorating profitability among non-financial firms (Chart II-5). Chart II-5Indonesia: Poor Profitability Among Non-Financial Companies Chart II-4Non-Financial & Small Caps Stocks: Dismal Performance   Only shares prices of three banks - Bank Central Asia, Bank Rakyat and Bank Mandiri - have been in a genuine bull market. These three stocks now account for 40% of the overall Indonesia MSCI Index and their rally has prevented an outright decline in the bourse. Chart II-6Indonesian Banks: Higher Provisions, Lower Profits We agree that these three banks are well provisioned and extremely well capitalized. Nevertheless, at a price-to-book value ratio of 4.7 for Bank Central Asia, 2.8 for Bank Rakyat and 1.8 Bank Mandiri, they are expensive. Given the ongoing economic slowdown and still high real borrowing costs, these three banks as well as all commercial banks in Indonesia will face higher NPLs and will be forced to provision for them. As NPL provisioning rise, banks’ profits will slow (Chart II-6). Such a scenario will likely lead to a 10-15% decline in these banks’ share prices in local currency terms. In U.S. dollars terms, the decline will be larger. Finally, as foreign investors in Indonesia begin digesting the magnitude of the country’s ongoing growth slump, their expectations for Indonesia’s return on capital will decline and they will likely reduce their exposure. This will trigger a selloff in the rupiah. Historically, foreign investors in Indonesia have cumulatively pumped $175 billion into debt securities and $105 billion into equity and investment funds. Indonesia’s lending rates remain elevated and well above nominal growth. Moreover, foreign ownership of local currency bonds and equities is high at 38% and 45%, respectively. Therefore, a decline in the rupiah will likely intensify the selloffs in the bond and equity markets. Bottom Line: For now, we continue recommending EM dedicated investors to remain underweight Indonesian equities, local currency bonds and U.S. dollar sovereign credit within their respective portfolios. We continue to recommend a short position in the IDR versus USD trade. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com South Africa: On An Unsustainable Path The backdrop for South African financial assets remains poor, despite the recent surge in precious metals prices and Federal Reserve easing. The rand will continue to depreciate, even if precious metals prices continue to rise. Such a decoupling will not be historically unprecedented. Chart III-1 shows the long-term relationship between gold and the rand. The rand has failed to rally on several occasions during periods of rising gold prices. Chart III-1Rand Has Diverged Historically From Gold Prices What’s more, contrary to popular narrative, the rand and the majority of EM currencies do not typically appreciate when U.S. interest rate expectations drop. We have elaborated on this topic in depth in previous reports. Ultimately, widening twin deficits, dwindling growth and declining return on capital will continue to depress the rand and risk assets. Supply constraints are preventing South Africa from capitalizing on rising gold prices – gold mining output is plummeting (Chart III-2). In fact, the trade deficit has been widening, despite surging gold prices (Chart III-3). Chart III-2Contracting Mining Output Chart III-3Rising Gold Prices ≠ Improving Trade Balance   The overall and primary fiscal deficits are also widening, as government revenues are slumping (Chart III-4). On top of this, the government recently announced a $4.2 billion (ZAR 59 billion) bailout for state-owned utility company Eskom, further worsening the country’s debt sustainability position. The combination of plummeting nominal GDP growth and still-high borrowing costs (Chart III-5) have also worsened debt dynamics among private borrowers, hurting private consumption and investment. Chart III-4Fiscal Deficit Will Widen Further Chart III-5Interest Rates Are Restrictive For Growth   Both business and household demand remain lackluster. South African non-financial companies’ return on assets (RoA) has been declining and has dropped below EM for the first time in the past 20 years (Chart III-6). Falling RoA has been due not only to cyclical growth headwinds but also structural issues such as lack of productivity growth. The falling RoA explains South African financial assets’ underperformance versus their EM counterparts. Finally, the rand is not very cheap (Chart III-7). Given poor fundamentals, including but not limited to a lack of productivity growth and a low and falling return on capital, the currency may need to get much cheaper. Chart III-6Non-Financials: Return On Assets Chart III-7The Rand Needs To Get Cheaper!   Overall, South Africa’s current macro dynamics are unsustainable. On the one hand, widening twin deficits will augment the country’s reliance on foreign funding. FDI inflows have been rather meager and are likely to stay that way. Hence, South Africa remains extremely dependent on volatile foreign portfolio inflows. Historically, foreign investors have cumulatively pumped $100 billion into debt securities and $120 billion into equity and investment funds. In turn, foreign portfolio inflows are contingent on a firm currency and high interest rates. Widening twin deficits, dwindling growth and declining return on capital will continue to depress the rand and risk assets. On the other hand, the economy is choking and public debt dynamics are worsening at a torrid pace due to high interest rates. Much lower domestic interest rates and a cheaper currency are necessary to reflate the economy and stabilize the public debt-to-GDP ratio. Ultimately, financial markets will likely push for a resolution of these contradictions. In the medium to long run, international capital flows gravitate towards countries that offer a high or rising return on capital. Provided return on capital in South Africa is very low and falling, foreign portfolio inflows will at some point diminish or grind to a halt. This will likely coincide with a negative global trigger for overall EM.  Reduced inflows or mild outflows of foreign portfolio capital will cause sizable rand depreciation. Bottom Line: The economy requires a cheaper rand and much lower interest rates to grow. The rand will likely act as a release valve: it will depreciate a lot, improving the trade balance, which in turn will ultimately allow interest rates to decline - although local bond yields will spike initially on rand weakness.  Investment recommendations: Remain short the rand versus the U.S. dollar, and underweight stocks and sovereign credit in respective dedicated EM portfolios. Concerning bonds, a depreciating rand will initially cause a selloff in local currency government bonds, warranting an underweight position for now. In the sovereign credit space, we are maintaining the following trade: sell CDS on Mexico / buy CDS on South Africa and Brazil. Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Portfolio Strategy The contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. It no longer pays to be overweight gold mining equities as sentiment is stretched, the restarting of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on global gold miners. EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Recent Changes Trim the Global Gold Mining index to neutral, today. Downgrade the S&P Materials sector to underweight, today. Table 1 Feature Equities broke out of their trading range last week, but in order for this short-covering rally to become durable, and for volatility to subside, either global growth needs to turn the corner and alleviate recession fears or the trade war needs to de-escalate materially. On the recession front Central Banks (CBs) are doing their utmost to reflate their respective economies, but the early stages of looser monetary policy have been insufficient to change the global growth trajectory. With regard to the trade war, markets cheered the news that talks between the U.S. and China will resume in September and October. The dates for talks are conveniently chosen to follow the September FOMC meeting and the October 1 70th anniversary of the People's Republic of China. The latter date implies that Washington is considering delaying the October 1 tariff hike – and it could imply that Washington does not anticipate any violent suppression of Hong Kong protesters by that time. However, the harsh reality is that the two sides are just “kicking the can down the road”. The longer the Sino-American trade war takes to conclude, the more likely it will serve as a catalyst for a repricing of risk significantly lower (top panel, Chart 1). A technical correction may be necessary to force Trump to reduce the trade pressure significantly. Even if the October 1 tariff hike is postponed it will remain a source of uncertainty ahead of the final tariff tranche slated for December 15. The bond market may offer some clues as to the extent that the escalating trade war will eventually get reflected into stocks (bottom panel, Chart 1). The equity transmission mechanism is through the earnings avenue. Simply put, rising trade uncertainty deals a blow to global trade that boosts the U.S. dollar which in turn makes U.S. exports uncompetitive in global markets, deflates the commodity complex and with a lag weighs on SPX earnings. Chart 1Tracking Trade Uncertainty Speaking of the economically hypersensitive manufacturing sector, last week’s ISM release made for grim reading, further fueling recession fears (the New York Fed now pegs the recession probability just shy of 38% by next August). Not only did the overall survey fall below the boom/bust line (middle panel, Chart 2), but also new orders collapsed. In fact, the drubbing in new orders is worrying and it signals that the economy is going to get worse before it gets better (top panel, Chart 2). Tack on the simultaneous rise in inventories, and the sinking new orders-to-inventories ratio (not shown) warns of additional manufacturing ills in the coming months. Importantly, export orders suffered the steepest losses plunging to 43.3. The last three times that this trade-sensitive survey subcomponent was in such a steep freefall were in 1998, 2001 and 2008, when the SPX suffered peak-to-trough losses of 20%, 49% and 57%, respectively. In fact, since the history of the data, ISM manufacturing export orders have never been lower with the exception of the GFC (Chart 3). Such a retrenchment will either mark the bottom for equities or is a harbinger of a steep equity market correction. We side with the latter as the odds of President Trump striking a real trade deal (including tech) with China any time soon are low. Chart 2Like Night Follows Day Similar to the ISM manufacturing/non-manufacturing divergence (bottom panel, Chart 2), business confidence is trailing consumer conference by a wide mark. Historically this flaring chasm has been synonymous with a sizable loss of momentum in the broad equity market (Chart 4). One plausible explanation is that as business animal spirits suffer a setback, CEOs are quick to prune/postpone capex plans and, at the margin, corporations retrench and short-circuit the capex upcycle. Chart 3Export Carnage Chart 4Mind The Gap Circling back to last week’s capex update, national accounts corroborate the financial statement data deceleration, and in some cases contraction, in capital outlays (Chart 5). As a reminder our thesis is that the EPS-to-capex virtuous upcycle is morphing into a vicious down cycle.1 This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Crucially, tech investment, that comprises almost 30% of total investment according to national accounts, is decelerating, R&D and other intellectual property investment have also hooked down, non-residential structures are on the verge of contraction, and industrial, transportation and other equipment –that have the largest weight in U.S. capex – are also quickly losing steam (Chart 6). Chart 5Capex Blues Chart 6All Capex Segments… In more detail, Charts 7 & 8 further break down capital outlays in the respective categories and reveal that worrisomely the investment spending slowdown is broad based. Chart 7…Have Rolled Over… Chart 8…Except For One Adding it all up, the contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. As a reminder, this is U.S. Equity Strategy service’s view and it contrasts with BCA’s sanguine equity market house view. This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Downgrade Materials To Underweight… Heightened economic and trade policy uncertainty has claimed the S&P materials sector as one of its victims (Chart 9). Given that our Geopolitical Strategy service’s base case remains that there will be no Sino-American trade deal by the U.S. November 2020 election, there is more downside for materials stocks and we are downgrading this niche deep cyclical sector to a below benchmark allocation.2 Beyond the U.S./China trade war inflicted wounds that materials stocks have to nurse, there are four major headwinds that they will also have to contend with in the coming months. Chart 9Trade Uncertainty Sinking Materials First, the emerging markets (EM) in general and China in particular are in a prolonged soft patch that predates the Sino-American trade war. EM stocks and EM currencies are both deflating at an accelerating pace warning that relative share prices will suffer the same fate (Chart 10). Nothing epitomizes the infrastructure spending/capex cycle more than China’s insatiable appetite for commodities and the news on that front remains dire. The Li Keqiang index continues to emit a distress signal and that is negative for materials top line growth (bottom panel, Chart 10). Second, global inflation is in hibernation and select EM producer price inflation growth series are on the verge of contraction or already outright contracting. Chinese raw materials wholesale prices are in the deflation zone and warn that U.S. materials sector profits will underwhelm (Chart 11). Chart 10Bearish EM… Chart 11…And China Backdrops Base metal prices are a real time indicator of the wellness of the S&P materials sector. Currently, base metals are deflating both on the back of a firming U.S. dollar and contracting global manufacturing. Such a commodity price backdrop is dampening prospects for a profit-led materials sector relative share price recovery (top & middle panels, Chart 12). Third, the materials exports outlook is darkening. Apart from the deflating effect the appreciating U.S. dollar has on commodities it also clips basic materials companies’ exports prospects. How? It renders materials related exports uncompetitive in international markets leading to market share losses. Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Chart 12Weak Pricing Power And Declining Exports In addition, the latest ISM export order subcomponent plunged to multi-year lows reflecting trade war pessimism and falling global end-demand. The implication is that the export relief valve is closed for materials equities (bottom panel, Chart 12). Finally, materials sector financial statement metrics are moving in the wrong direction. Net debt-to-EBITDA is rising anew and interest coverage has likely peaked for the cycle at a time when free cash flow generation has ground to a halt (Chart 13). U.S. Equity Strategy’s S&P materials sector profit growth model encapsulates all these moving parts and warns that a severe profit contraction phase looms (Chart 14). Chart 13Financial Statement Red Flags Chart 14Model Says Sell Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Bottom Line: The time is ripe to downgrade the S&P materials sector to underweight. …Via Trimming Gold Miners To Neutral The way we are executing this downgrade in the materials sector to an underweight stance is by trimming the global gold mining index to a benchmark allocation. Our thesis that gold stocks serve as a sound portfolio hedge remains intact and underpinned when: economic and trade policy uncertainty are on the rise (top panel, Chart 15) global CBs start cutting interest rates and in some cases doubling down on negative interest rates currency wars are overheating Nevertheless, what has changed is the price, and we deem that global gold miners that have gone parabolic are in desperate need of a breather. The top panel of Chart 16 shows that gold stocks have rallied 58% since the May 5, 2019 Trump tweet. This outsized four-month relative return is remarkable and likely almost fully reflects a very dovish Fed and melting real U.S. Treasury yields (TIPS yield shown inverted, bottom panel, Chart 15). A much needed pause for breath is required before the next leg of the relative rally resumes, and we opt to move to the sidelines. Chart 15Positive Backdrop… Chart 16…But Reflected In Prices Moreover, on the eve of the ECB’s September meeting, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as markets participants expect, counterintuitively a selloff in the bond markets would confirm that QE and its signaling is working (bottom panel, Chart 16). Ergo, this would likely exert upward pressure on global interest rates including the U.S., especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise further. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Sentiment toward gold and global gold miners is stretched. Gold ETF holdings are at multi-year highs (second panel, Chart 17) and gold net speculative positions are at a level that has marked previous reversals. In addition, bullish consensus on gold is near 72%, a percentage last reached in 2012 (third & bottom panels, Chart 17). Similarly, relative share price momentum is also warning that global gold mining equities are currently extended (bottom panel, Chart 18). Chart 17Extreme… Chart 18…Sentiment Finally, while the bond market’s view of 100bps in Fed cuts in the next 12 months should have undermined the trade-weighted U.S. dollar, it has actually defied gravity and slingshot to fresh cycle highs. This is a net negative both for gold and gold mining equities as the underlying commodity is priced in U.S. dollars and enjoys an inverse correlation with the greenback. The implication is that the multi-decade inverse correlation will hold and will likely pull down gold and gold mining equities at least in the short-run (U.S. dollar shown inverted, Chart 19). In sum, the exponential rise in global gold miners is in need of a breather. Sentiment is stretched, the restating of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on relative share prices Chart 19Gold Miners/Dollar Correlation Re-establishment Risk Bottom Line: Downgrade the global gold mining index to neutral, but stay tuned.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      Please see U.S. Equity Strategy Weekly Report, “Capex Blues” dated September 3, 2019, available at uses.bcaresearch.com 2      Please see The Bank Credit Analyst Special Report, “Big Trouble In Greater China” dated August 29 , 2019, available at bca.bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps

Highlights Global bond yields have closely tracked the trajectory of global growth. While the global economy remains fragile, some positive signs are emerging: Our global leading economic indicator has moved off its lows; global financial conditions have eased significantly; U.S. household spending remains resilient; and China is set to further increase stimulus. Neither a severe escalation of the trade war nor a hard Brexit is likely. A simple comparison between current dividend yields and bond yields implies that global equities would need to fall by an outsized amount over the next decade for bonds to outperform stocks. As global growth stabilizes and then begins to recover over the coming months, bond yields will rebound from depressed levels. Investors should overweight stocks versus bonds for now, and look to upgrade EM and European equities later this year. Feature Global Growth Driving Bond Yields Chart 1Global Bond Yields: How Low Will They Go? Global bond yields rose sharply yesterday on word that U.S. and Chinese trade negotiators will meet in October. The announcement by China’s State Council of additional stimulus measures and better-than-expected data on the health of the U.S. service sector also drove the bond sell-off. The jump in yields follows a period of almost unrelenting declines. After hitting a high of 3.25% last October, the U.S. 10-year yield fell to 1.43% this Tuesday, just shy of its all-time low of 1.34% reached on July 5, 2016. The 30-year Treasury yield broke below 2% for the first time in history on August 15, falling to as low as 1.91% this week. It now stands at 2.07%. In Japan and across much of Europe, bond yields remain firmly in negative territory (Chart 1). The large movements in bond yields can be attributed to both the state of the global economy as well as to changes in how central banks are reacting to economic uncertainty. Just as stronger global growth pushed yields higher between mid-2016 and early-2018, the deceleration in growth since then has pulled yields lower. Chart 2 shows that there has been a close correlation between changes in the U.S. 10-year yield and the ISM manufacturing index. The release on Tuesday of a weaker-than-expected ISM manufacturing print for August was enough to push the 10-year yield down by seven basis points within a matter of minutes. Chart 2The Deceleration In Growth Has Pulled Yields Down The forward-looking new orders component of the ISM manufacturing index sunk to a seven-year low. The export orders component fell to the lowest level since 2009. Export volumes track ISM export orders quite closely (Chart 3). Not surprisingly, the ISM press release noted that trade remains “the most significant issue” for U.S. manufacturers. Chart 3Export Volumes Track The ISM Export Component The only redeeming feature in the report was that the customers’ inventories index dropped a notch from 45.7 in July to 44.9 in August. A reading below 50 for this subindex indicates that manufacturers believe that their customers are holding too few inventories, which is positive for future production. Global Manufacturing PMI Not Looking Much Brighter The Markit global manufacturing PMI remained below 50 for the fourth month in a row in August. While the global PMI did edge up slightly from July’s reading, this was largely due to a modest rebound in the Chinese PMI, which rose from 49.9 to 50.4. The improvement in the China Markit-Caixin PMI stands in contrast to the further deterioration observed in the “official” National Bureau of Statistics PMI. The former is more heavily geared towards private-sector exporting companies, and hence may have been influenced by the front-loading of exports ahead of the planned tariff increase on Chinese exports to the United States. Some Positive Signs Chart 4Global LEI Has Moved Off Its Lows In light of the disappointing manufacturing data, it is too early to call a bottom in the global industrial cycle. Nevertheless, there are some hopeful signs. Our Global Leading Economic Indicator (LEI) has moved off its lows (Chart 4). It usually leads the PMIs by a few months. Sterling will probably be the best performing currency in the G7 over the next five years. Despite ongoing weakness in the manufacturing sector, household spending has held up in most economies. In the U.S., the nonmanufacturing ISM index jumped to 56.4 in August from 53.7 in July. Real personal consumption is still on track to grow by 2.8% in Q3 according to the Atlanta Fed (Chart 5). The euro area services PMIs have also been resilient (Chart 6). In Germany, where the manufacturing PMI stood at 43.5 in August, the services PMI rose to 54.8.  Chart 5Inventories And Net Exports Have Subtracted From U.S. Growth In Q2 And Q3 Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) Global financial conditions have eased significantly, mainly thanks to the steep decline in bond yields. The current level of financial conditions implies that global growth could rebound swiftly (Chart 7). The Chinese government is also likely to step up fiscal/credit stimulus over the coming months in an effort to shore up growth. In a boldly worded statement released on Wednesday, the Chinese State Council promised to further increase bond issuance to finance infrastructure projects, while cutting interest rates and reserve requirements. A stronger Chinese economy should benefit global growth (Chart 8). Chart 7Easier Financial Conditions Will Benefit Global Growth Chart 8Stronger Chinese Growth Should Benefit The Global Economy   The Trade War: Moving Towards A Détente? The announcement that the U.S. and China will resume trade negotiations on October 5th is a step in the right direction. As we noted last week, both parties have an incentive to de-escalate the trade conflict. President Trump wants to prop up the stock market and the economy in order to improve his re-election prospects. China also wants to bolster growth.1 Chart 9Would China Really Be Better Off Negotiating With A Democrat As President? As difficult as it has been for China to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would be especially the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more palatable to deal with on trade matters. Does the Chinese government really want to negotiate over labor standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 9)? While Republicans in Congress would be able to restrain a Democratic president on domestic issues, the president would still enjoy free rein over trade policy.   Brexit Uncertainty Adding To Investor Angst Two weeks before the Brexit vote on June 23, 2016, I wrote that “Just like my gut told me last August that Trump would do much better at the polls than almost anyone thought possible, I increasingly feel that come June 24th, the EU may find itself with one less member.”2 Chart 10Brexit Opposition Has Been Growing Soon after the shocking verdict, we argued that a hard Brexit would prove to be politically infeasible, meaning that the U.K. would either end up holding another referendum or be forced to negotiate some sort of customs union with the EU. Our view that a hard Brexit will not happen has not changed. Chart 10 shows that opposition to Brexit has only grown since that fateful day. Boris Johnson does not have enough votes in Westminster to force a hard Brexit. Another election would not change this outcome, given that it would almost certainly produce a hung parliament. In any case, it is not clear that Johnson actually wants a hard Brexit. The Times of London recently reported that the government’s own contingency plans for a hard Brexit, weirdly code-named “Operation Yellowhammer,” predicted a crippling logjam at British ports leading to shortages of fuel, food and medicine.3  Boris Johnson is all hat and no cattle. He will be forced to make a deal with the EU. Buy the pound on any dips. Sterling will probably be the best performing currency in the G7 over the next five years. Central Banks: Cut First, Ask Questions Later Chart 11Inflation Expectations Are Low Across The Globe Despite a few glimmers of good news, central banks are in no mood to take any chances. St. Louis Fed President James Bullard said it bluntly last week: “Our job is to get the yield curve uninverted.”4 If history is any guide, global growth will stabilize and begin to recover over the coming months. Inflation expectations are below target in most economies (Chart 11). Central banks know full well that if the current slowdown morphs into a full-blown recession, they will be out of monetary ammunition very quickly. In such a setting, it does not make sense to hold your punches. Much better to generate as much inflation as possible, and as soon as possible, so that real rates can be brought deeper into negative territory if economic circumstances later warrant it. What If The Medicine Works? The risk of easing monetary policy too much is that economies will eventually overheat, producing more inflation than is desirable. It is easy to forget that the aggregate unemployment rate in the G7 is now below its 2007 lows (Chart 12). True, inflation has yet to take off, but this may simply be because inflation is a lagging indicator (Chart 13). Chart 12Unemployment Rates Keep Trending Lower Chart 13Inflation Is A Lagging Indicator For all the talk about how the Phillips curve is dead, the empirical evidence suggests it is very much alive and well (Chart 14). Ironically, this means that lower interest rates today could set the stage for much higher rates in the future if hyperstimulative monetary policies ultimately generate a bout of inflation.  Chart 14The Phillips Curve Is Alive And Well Chart 15The Dollar Is A Countercyclical Currency   Investment Conclusions Like most economic forecasters, central banks tend to extrapolate recent trends too far into the future. Global growth has been weakening since early 2018 so it seems reasonable to assume that this trend will persist into next year. However, as we have documented, global industrial cycles tend to last about three years – 18 months of rising growth followed by 18 months of falling growth.5 If history is any guide, global growth will stabilize and begin to recover over the coming months. Should that occur, we will enter an environment where the lagged effects of easier monetary policy are hitting the economy just when the manufacturing cycle is taking a turn for the better. Stocks are likely to fare well in such a setting, while long-term bond yields will move higher. As a countercyclical currency, the dollar will also start to weaken anew (Chart 15). Granted, an intensification of the trade war or some other major adverse shock would upset this rosy forecast. Nevertheless, current market pricing offers a fairly large cushion against downside risks. Thanks to the drop in bond yields, the equity risk premium is quite high globally (Chart 16). Even if one were to assume that nominal dividend payments remain unchanged for the next ten years, the S&P 500 would still need to fall by more than 20% in real terms over the next decade for bonds to outperform stocks (Chart 17). Euro area stocks would need to drop by more than 42%. U.K. stocks would need to plummet by at least 60%! Chart 16AEquity Risk Premia Remain Quite High (I) Chart 16BEquity Risk Premia Remain Quite High (II) Chart 17AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 17BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Investors should remain overweight stocks versus bonds over the next 12 months. We intend to upgrade EM and European equities once we see a bit more evidence that global growth has troughed.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “A Psychological Recession?” dated August 30, 2019. 2Please see Global Investment Strategy Weekly Report, “Worry About Brexit, Not Payrolls,” dated June 10, 2016. 3Rosamund Urwin and Caroline Wheeler, “Operation Chaos: Whitehall’s Secret No-Deal Brexit Preparations Leaked,” The Times, August 18, 2019. 4“Fed’s Bullard Sees ‘Robust Debate’ Over Half-Point Cut,” Bloomberg, August 23, 2019. 5Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM   How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies   Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields.  Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile   We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates   Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling  further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth   An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot   Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse   We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade   Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Chart 5Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. 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