Monetary

Highlights The Chinese economy is still slowing, and there is not yet enough evidence from forward-looking economic data to suggest a turnaround is imminent. Deflation has returned to China’s industrial sector. Even though overall price deceleration has been relatively mild, it is further squeezing already deteriorating industrial profit growth. We do not expect deflation to spiral into a 2015/2016-style episode, which removes at least one risk to our growth outlook. At the same time, a mild deceleration in prices will not provide enough incentive for Chinese policymakers to hit the stimulus button.  The People’s Bank of China’s new interest rate-setting regime, the LPR, will not provide much in the way of stimulus over the next few months. But it has the potential to improve China’s monetary policy transmission mechanism over the coming year, increasing the odds that policymakers will succeed in stabilizing economic activity. Short-term downside risks to growth have not abated, and we remain tactically bearish on Chinese stocks. Cyclically, we continue to recommend an overweight stance, on the basis of an eventual reacceleration in economic activity. Feature Chart 1The Chinese Economy Is Still Slowing China’s economy is at a critical juncture: “Half-measured” stimulus so far has been able to keep the domestic economy in better shape than in the 2015-2016 down cycle, but overall economic activity has not bottomed (Chart 1). The Sino-America trade talk has resumed at the moment, but the two sides have yet to make any substantive progress towards a deal. In the meantime, the global economy has also reached a critical point where the degree of economic weakness has the potential to feed on itself, possibly triggering a recession.1  This underscores our tactically bearish stance towards Chinese stocks versus the global equity benchmark. Barring more forceful stimulus or resolution on the trade front, any external shock and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown. Hence, downside risks remain elevated for Chinese stocks over the next 3- to 6-months.    The “D” Word Returns, But Won’t Spur Aggressive Further Easing Chart 2Industrial Price Deflation Returns Economic data over the past two months have provided mixed signals. Readings from both China’s National Bureau of Statistics (NBS) PMI and from the Caixin PMI show an improvement in the manufacturing sector. However, industrial deflation has returned to China: Three years after the country declared victory against a prolonged industrial destocking cycle, producer price inflation (PPI) relapsed into negative territory in July and declined further in August (Chart 2).   While prices are typically lagging indicators and reflect lingering effects from past economic conditions, there is not enough evidence in forward-looking economic data right now to suggest a turnaround in the economy is imminent.2  A deflationary PPI is not a trivial source of concern for Chinese policymakers. Last time growth in China’s PPI turned negative, it took policymakers four and a half years and an annualized 28% of GDP worth of credit expansion to pull the industrial sector out of its deflationary cycle. Chart 3Deflation Threatens Recovery In Industrial Profit Growth For investors, deflation has pernicious effects on profits, and we have received several client inquiries concerning the topic since PPI growth turned negative. The historical relationship suggests profit growth for both the A-share and investable markets is highly linked to fluctuations in producer prices (Chart 3), and China’s industrial sector profit growth has already been rapidly deteriorating over the past 12 months. The good news is that we do not expect the current episode of PPI deflation to become as protracted as it did in 2012-2016, or as severe as in 2015-2016. Two reasons underpin our view: Since early-2018, monetary policy has been much easier than during past deflationary episodes. Monetary policy in the past year and half has been much more accommodative than in the three years leading to the deep industrial deflationary cycle in 2015, particularly on the exchange rate front. The RMB was soft-pegged to a rising U.S. dollar before it was decoupled by the PBoC in August 2015, and was appreciating against its trading partners throughout most of 2012-2015. Bank lending rates were also kept at historically high levels during this period (Chart 4). This time, even though money and credit growth has not returned to the same pace as in 2015-2016, current ultra-loose monetary conditions should spur enough credit growth to keep prices from deflating aggressively. Chart 4Monetary Conditions Easier Than Last Cycle Inventory levels are low, and capacity levels do not appear to be overly excessive. After years of industrial consolidation, China’s industrial capacity does not appear to be particularly excessive compared to the past cycle. This is distinctively different from the prolonged contraction in PPI between 2012 and 2016, when China’s industrial inventories were coming off a five-year-long destocking cycle, and capacity utilization fell markedly (Chart 5). This is not the case today. Moreover, even though final demand has been weak, production has retrenched even more, drawing down inventories to the point where the pace of inventory destocking may have reached a cyclical bottom (Chart 6). A re-stocking of industrial goods should boost producers’ pricing power. Chart 5Capacity Is Not Excessively Underutilized Chart 6Inventory Destocking May Be Bottoming Out But the bad news (for investors), is that contained, or mild producer price deflation will not be reason alone to spur aggressive further easing from policymakers. This means that the re-emergence of price deflation, even mild and short-lived, will weigh on earnings and investor sentiment. Bottom Line: This episode of producer price deflation is unlikely to become as pernicious as occurred in the past, but policymakers are thus unlikely to act aggressively to counter it. While this removes some of the downside risks for Chinese stocks, even mild deflation will weigh on earnings growth (and thus sentiment) which underscores our tactically bearish stance on Chinese stocks. Demystifying China’s New Loan Prime Rate: Not The Stimulus You Are Looking For On August 20th, the PBoC launched a new loan prime rate (LPR) system, a revamped reference regime for setting bank loan interest rates3 (Chart 7). In September, the new LPR rate for one-year bank loans was lowered by five basis points. Since then, the market has been fixated on predicting whether the PBoC will cut the Medium-Lending Facility (MLF) rate next, which would be perceived as a change in China’s monetary stance. Chart 7China's New LPR: A Shadow 'Tax Cut' PBoC will increase its control of the pricing of credit, while tight financial regulations will restrict the size and speed of credit growth. The new LPR reform, in our view, is designed to force state-owned (and better-capitalized) commercial banks to hand out a “tax cut” to struggling small- and medium-sized enterprises (SMEs) by lowering bank lending rates. At the same time, it allows the PBoC to take back control of the pricing of credit from commercial banks, “killing two birds with one stone.” There are three main market implications from this approach: The new LPR is likely to gradually narrow the gap between corporate bond yields (i.e. “market rates”) and bank lending rates; A cut in the MLF rate in the near term should be interpreted as a “reward” to commercial banks rather than a stimulus for the economy; Most importantly, the new LPR system does not mean rapid credit expansion is in the cards. Quite the opposite, in the near term, banks may tighten their lending. The wide spread between the 3-month interbank repo rate and average bank lending rate illustrates the reason why the PBoC has introduced the LPR.4 This gap is also evident when comparing the yield of AAA-rated corporate bonds and the average bank lending rate (Chart 8). These gaps exist because Chinese commercial banks have largely manipulated the 1-year bank lending rate set by the PBoC when lending to their “preferred customers,” usually state-owned enterprises and real estate developers, by offering significantly discounted loan rates. Banks then charge substantial “risk premiums” on loans to the private sector, mostly SMEs, to make up for the narrower profit margins on loans to SOEs (Chart 9). Chart 8An Impaired Monetary Policy Transmission Mechanism Chart 9Evidence Of Asymmetrical Lending Practices The new LPR system is designed to minimize this discrepancy, since the new LPRs are more market based and are quoted based on the price of loans banks charge their prime clients. By design, the new LPR system should force the average bank lending rate closer to the rate companies borrow in the bond market. This means bank lending rates will be guided lower, including lending rates for SMEs. However, the new system will be implemented in phases, and the PBoC is likely to gradually guide LPRs lower to allow banks to readjust their pricing models.  The LPR rate is essentially the MLF rate plus bank profit margins (the added basis points above the MLF rate). The market will guide the top line lending rate, while the PBoC will have control over the floor rate (MLF) through open market operations. The fact that the PBoC is keeping the MLF rate unchanged while allowing the LPR to drop (albeit slightly) sends an explicit message: The PBoC is forcing banks to lower lending rates first before boosting their now-narrowed profit margins by lowering the MLF rate. In contrast to expectations of market participants that the LPR system will ease credit conditions, banks may actually tighten their lending in the coming months. While the PBoC will increase its control of the pricing of bank loans by the rate reform plan, the strengthening in financial regulations that has occurred over the past year will restrict the size and speed of credit growth. This combination has created more room for monetary easing without unleashing “animal spirits.” Borrowing costs to risky institutions have been higher since the Baoshang Bank takeover and are likely to remain elevated even if interest rates are lower (Chart 10). More importantly, mortgage and real estate developer loans together account for nearly 30% of total bank credit. Unless policymakers ease the brakes on lending restrictions to the property sector, bank lending growth is unlikely to pick up meaningfully (Chart 11). In fact, the PBoC has explicitly excluded mortgage and property-related lending from benefitting from the LPR rate cut.5 Barring a significant worsening in economic data, we do not expect the PBoC to lower mortgage lending and real estate-related loan rates in the coming months. Chart 10Tightened Financial Regulations Will Keep Cost Of Risky Lending High Chart 11Mortgage Rate Unlikely To Return To Its 2016 Low Finally, in the next two- to three-quarter mandatory implementation period, banks will be readjusting their pricing and credit risk-assessing models. During the transition, we expect more cautious sentiment among both lenders and borrowers. Hence, in the short term, bank loan growth may actually moderate. Bottom Line: The new LPR system may lower China’s banking sector profits in the short term. But in the next 6- to 12-months, we expect the PBoC to compensate commercial banks by keeping ample liquidity in the interbank system and by eventually lowering the MLF rate. The new LPR system may slow bank credit growth in the next few months, but after its full implementation (by the second quarter of 2020), it will have the potential to make PBoC’s policy more effective. Investment Conclusions We expect two phases of Chinese equity relative performance over the coming year: one phase of flat-to-potentially seriously down performance to last from now until sometime in the first quarter of 2020 when the economy bottoms, and then a phase of outperformance. Our expectation that the economy will bottom in Q1 2020 rests on the existing reflationary response by Chinese policymakers and an improved monetary transmission mechanism. Chart 12We Expect The Chinese Economy To Bottom In Q1 2020 Our expectation that the economy will bottom in the first quarter of 2020 continues to rest on the existing reflationary response by Chinese policymakers (Chart 12), and the fact that China’s new LPR system has the potential to improve what is currently a seriously impaired monetary transmission mechanism beyond the next two or three quarters. But the existing response of policymakers has been considerably more measured when compared to past economic cycles, meaning that equity investors are unlikely to be as forward-looking as they otherwise might be. Weak producer price deflation will weigh on investor sentiment, and it is unlikely to be weak enough to spur aggressive further easing. The potential for further escalation of the U.S.-China trade war also compellingly argues against an overweight stance in the near-term, even if we expect economic growth to subsequently improve. Consequently, we remain tactically bearish and cyclically bullish towards Chinese stocks: medium-term investors who are already positioned in favor of China-related assets should stay long, whereas investors who have not yet moved to an overweight stance should wait for a better buying opportunity to emerge over the coming few months.   Jing Sima China Strategist JingS@bcaresearch.com     Footnotes 1      Please see Global Investment Strategy Outlook “Fourth Quarter 2019 Strategy Outlook: A “Show Me” Market”, dated October 4, 2019, available at gis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report “China Macro And Market Review”, dated October 2, 2019, available at cis.bcaresearch.com 3      Announcement of the People’s Bank of China on Improving Loan Prime Rate (LPR) Formation Mechanism, August 19, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877490/index.html 4      PBC Official Answers Press Questions on Improving Loan Prime Rate (LPR) Formation Mechanism, August 20, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877865/index.html 5      Announcement of the People’s Bank of China No.16, August 27, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3881177/index.html Cyclical Investment Stance Equity Sector Recommendations

Highlights The slowdown in the U.S. manufacturing sector is at risk of becoming deeper than elsewhere. This is not bearish for the U.S. dollar, given that it is a countercyclical currency, but it is not a constructive development, either. This impasse can be solved by an easier Federal Reserve, which would knock down the dollar. For now, we are maintaining our trade focus on the crosses rather than on outright dollar bets. The Swiss National Bank is likely to start weaponizing its currency, given the domestic slowdown: Go long EUR/CHF at 1.06. Long yen positions have become a consensus trade, but we will await a better exit point for our short USD/JPY positions. Feature The Swiss economy is slowly stepping into deflation. The latest inflation print this week stood at 0.1%, well below the SNB’s central forecast of 0.4% for this year. Goods inflation has completely ground to a halt, while service inflation is now at the lowest level since 2016. If left unchecked, this could begin to un-anchor inflation expectations, leading to a negative feedback loop that the SNB will likely find very difficult to lean against (Chart I-1). Chart I-1The SNB Will Have To Lean ##br##Against This Chart I-2A Strong Franc Is Exerting A Powerful Deflationary Impulse Global disinflationary trends are definitely playing a role, but the strong currency has been front and center at exacerbating these trends. As a small, open economy, tradeable goods prices are important for Switzerland. Import prices are deflating by over 3% year-on-year, in part driven by a strong trade-weighted currency (Chart I-2). This is increasing the odds that the SNB will begin to use the currency to stimulate monetary conditions. Operation Weak Franc Chart I-3How Long Can You Defy The Pull Of Gravity? Domestically, the Swiss economy is holding up well, but it is an open question as to how much longer it will continue to defy the pull of a slowing external sector. The KOF employment indicator is at its highest level since 2010, and the expectations component continues to exceed the current assessment. During normal times, this is a bullish development. However, for a highly export-driven economy, the manufacturing sector usually dictates trends in the overall economy (Chart I-3). The manufacturing PMI print is currently sitting at 44.6, the worst since the financial crisis. These levels have usually rung loud alarm bells along SNB corridors. Back in 2011, Switzerland was rapidly stepping back into deflation, having just barely escaped it a year earlier. The SNB quickly realized that for a small, open economy, the exchange rate often dictates the trend in domestic inflation. Ergo, sitting and watching the trade-weighted Swiss franc continue to appreciate, especially given the euro was in a cascading downdraft, appeared to be a recipe for disaster. This sounds eerily similar to today. With the European Central Bank resuming quantitative easing and with an SNB that left rates unchanged at its most recent policy meeting, the signal is that interest rates have probably hit a floor. This view is further reinforced by the SNB’s additional tiering of reserves. In other words, rates have probably begun to teeter on the edge of financial stability. This leaves the currency as the policy tool of choice. Our bias is that the whisper floor of 1.08-1.10 for EUR/CHF will continue to persist until the Swiss economy decisively exits deflation. However, markets can tilt the Swiss exchange rate to an overshoot. If that happens, four key factors suggest the Swiss economy needs a weaker currency, especially versus the euro: The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade. The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade (Chart I-4). However, in a downturn, while commoditized goods prices are the first shoe to drop, the slowdown eventually starts to infect more specialized goods prices. Swiss goods are not easily substitutable, but other countries such as Sweden that have dropped their currency will benefit more from any recovery. Chart I-4Rising Terms Of Trade Have Helped ##br##Support Exports Chart I-5A Gold ##br##Haven Part of the improvement in the Swiss trade balance has been driven by precious metals exports. For example, exports of precious metals to the U.K. are soaring towards new highs as storage demand for ETF accounts rises (Chart I-5). However, there has been a lack of physical demand in Asia, while the riots in Hong Kong are causing gold to be rerouted to Switzerland, then London. This might soon end. Our models suggest the franc is now almost 10% overvalued versus the euro. Over the history of the model, franc overvaluation peaks at a high of 15%, and is often followed by intervention by the SNB (Chart I-6). While the unemployment rate is at 2.3%, domestic wage pressures are none existent. It will be difficult for service inflation to pick up without a build-up in wage pressures. This is unlikely to happen over the next six to nine months. Part-time employment continues to dominate job gains, meaning the need for precautionary savings will continue to restrain spending. Meanwhile, the manufacturing sector is unlikely to start raising wages before a recovery is in sight. However, more recently, foreign exchange reserves have started reaccelerating and the stability in the monetary base suggests some spectre of sterilization. It has been surprising that in the global race towards lower rates and amidst the potential for global currency devaluation, the SNB has been sitting and watching other central banks like the ECB and the Riksbank eat part of its lunch. The message from SNB Central Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market if necessary. This might slightly suggest disagreement within the governing council. Chart I-6The Franc Is ##br##Expensive Chart I-7Is The SNB Sterilizing Reserve Accumulation?   Interestingly, the SNB has not had to ramp up its balance sheet significantly in recent years. Part of the reason is that the slowdown in global trade eased natural demand for francs, which meant the SNB was no longer accumulating foreign exchange reserves at a rampant pace. This has helped drain excess liquidity from the system and somewhat renormalize policy. This means that the wiggle room for more FX intervention has reopened. However, more recently, foreign exchange reserves have started reaccelerating, and the stability in the monetary base suggests some spectre of sterilization (Chart I-7). Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G-10. Too little stimulus and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations continue to be anchored strongly to the downside. Too much stimulus, and the result will be a build-up of imbalances, leading to an eventual bust. Currency Cap Post-Mortem While the SNB may favor stealth depreciation of the franc, there are both political and economic constraints to an outright cap. The good news is that the economic forces are ebbing as the economy slows down. Meanwhile, there had already been a rising chorus of discontent among right-wing politicians in 2014, specifically those within the Swiss People’s Party (SVP) who wanted the central bank to stop buying foreign currencies and significantly lift its gold holdings instead. With the SVP currently ahead in opinion polls ahead of this month’s elections, this is likely to remain a constraint. The good news is that new issues such as climate change have taken the fore, rather than whether Switzerland should start backing it reserves via gold (Chart I-8). The key risk to a cap is that if the euro drops substantially, it will invite speculation back into the Swiss economy. This risk is clearly unpalatable for both Swiss politicians and the SNB, which is why two-way asymmetry was reintroduced into the system in 2015. Chart I-8The Swiss People's Party Will ##br##Like This Up! Chart I-9A Healthy ##br##Rebalancing On a positive note, housing market speculation has been somewhat cleansed. Growth in rental housing units, which usually constitutes the bulk of investment homes, has grown to a standstill, and this is positively deviating from growth in owner-occupied homes. The message from this is clear: Macro-prudential measures such as a cap on second homes as well as stricter lending standards have helped (Chart I-9). Back in 2015, the SNB smartly surprised the market by abandoning the EUR/CHF floor. This helped rebalance the market as European investors who used the SNB put to speculate on properties in Zurich and Geneva were dis-incentivized once the euro collapsed. Demand for Swiss real estate has largely stabilized since then, eliminating this key source of risk for the SNB. The SVP’s curb on immigration has neutered a meaningful source of demand. Vacancy rates for rental properties have started to inflect meaningfully higher. More importantly, vacancy rates for rental properties have started to inflect meaningfully higher. This has usually led to lower housing prices, with a lag of about 12 months (Chart I-10). With the SVP unlikely to become more pro-immigration anytime soon, this will likely remain a headwind (Chart I-11). This suggests the political capital for the SNB to use stealth depreciation of the currency to stimulate the economy is high, especially as the global economy remains mired in a manufacturing downturn. A history of budget surpluses suggests that the SVP is unlikely to pass any significant pro-fiscal policies at any time soon. Chart I-10Slowing Migration Is Curbing Housing Demand Chart I-11A Slowing Workforce Is Curbing Housing Demand Claims on bank balance sheets from foreigners are relatively low, meaning the risk from an inflow of capital into the housing market on a lower exchange rate is low (Chart I-12). With bank lending margins likely to be depressed for the next few years, some foreign inflows into the real estate sector would help, alongside stricter macro prudential measures. Chart I-12Banks Have Low Foreign Mortgage Liabilities On EUR/CHF And USD/CHF Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of 115% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion (Chart I-13). Meanwhile, hedging costs for short CHF trades are less attractive than a year ago. They might get more prohibitive but until then, we suggest prudence in going short the franc versus the euro or USD (Chart I-14). Our bias however, is that the SNB will significantly start to lean against the franc at 1.06. Chart I-13Risk: Swiss Franc Tends ##br##To Appreciate Chart I-14Hedging Costs Are ##br##Prohibitive   Investment Conclusions Chart I-15Major Dollar Tailwinds Have Peaked We continue to focus on trades at the crosses, and holding portfolio insurance such as the Swiss franc remains what the doctor ordered. Our objective in this week’s report was to highlight that investors and traders may not want to overstay their welcome, and as such keep a watchful eye on tentative signs of a reversal. Typically, the growth divergence between the U.S. and the rest of the world has been a good explanatory variable for medium-term fluctuations in the dollar. Ergo, the deceleration in the U.S. manufacturing PMI usually foretells a bad omen for the dollar (Chart I-15). The franc tends to do well at the crosses during dollar bull markets and poorly during dollar bear markets. However, there are benign adjustments and malignant ones, and a drop in the U.S. manufacturing PMI, driven by much slower global growth, looks like the malignant type. What we will need to see, if the weak dollar narrative is to pan out, is stabilization in the U.S. manufacturing sector, as the rest of the world’s manufacturing sector inflects higher. This will also weaken the franc at the crosses. Stay tuned.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 There was a flurry of U.S. data releases, the balance of which was negative: Headline PCE was unchanged at 1.4% year-on-year in August. Core PCE increased to 1.8% year-on-year. Chicago purchasing managers’ index fell to 47.1 in September from 50.4 in August. Dallas Fed manufacturing business index fell to 1.5 in September from 2.7 in August. ISM manufacturing PMI plunged to 47.8 in September, the second consecutive month below 50. Moreover, ISM non-manufacturing PMI fell to 52.6 in September from 56.4, well below expectations of 55. Admittedly, the Markit composite PMI was up at 51 versus 50.7 the prior month. ADP non-farm payrolls were below expectations at 135K in September, versus 157K in August. Durable goods orders monthly growth slowed to 0.2% in August. Factory orders contracted by 0.1% month-on-month in August. DXY index rose by 0.6% initially, then plunged, losing 0.4% this week. The deterioration in both ISM manufacturing and non-manufacturing PMIs spurred worry about an imminent recession. We get the jobs report this Friday, which is one of the last pillars of support for a relatively hawkish Fed policy. On the monetary policy front, the Fed will resume the balance sheet expansion. The increase in supply of dollars will add to the forces that might eventually pull the dollar lower. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Inflation remains subdued across euro area countries in August. Headline inflation in the euro area fell to 0.9% year-on-year from 1%. In France, the headline inflation declined to 1.1% year-on-year from 1.3%. In Spain, it fell to 0.1% year-on-year from 0.3%. In Germany, it also decreased to 1.2% year-on-year from 1.4%. The unemployment rate in the euro area marginally decreased to 7.4% in August from 7.5%. The economic sentiment indicator in the euro area fell to 101.7 in September from 103.1. Producer price index fell by 0.8% year-on-year in August. Retail sales growth was little changed at 2.1% year-on-year in August. EUR/USD increased by 0.6% this week. On the inflation front, the steeper drop in CPI for core countries rather than the peripheral ones suggests that the redistributive efforts needed to hold the euro area together are somewhat working. ECB president Mario Draghi called for an “investment-led stimulus at the euro area level” in a speech in Athens on Tuesday evening, but the reality is that the peripheral countries are already using lower rates to deploy capital. J.P. Morgan analysts have upgraded European equities this week. If equity fund flows start to rise, the euro is likely to rebound against the U.S. dollar. Report Links: A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been disappointing: The all-important Tankan survey came out this week. There was deterioration in both the manufacturer and service outlook in Q3, but it was admittedly above expectations. Plans for capex remained relatively elevated. Industrial production contracted by 4.7% year-on-year in August. Retail sales increased by 2% year-on-year in August, but we are downplaying this because of the consumption tax hike. Housing starts decreased by 7.1% year-on-year in August. Construction orders fell by 25.9% year-on-year (the latter being extremely volatile). The unemployment rate was unchanged at 2.2% in August. Jobs-to-applicants ratio was also unchanged at 1.59. Consumer confidence fell to 35.6 in August, from 37.1 in July. We have discussed in length the significance of this in a Ricardian equivalence framework. Services PMI fell to 52.8 in September, while still above the 50 expansionary territory. USD/JPY fell by 1% this week. In the recent Summary of Opinions, the BoJ highlighted risks of lower external demand due to delayed economic growth. On the positive side, various countermeasures are set to mitigate the negative effects of the tax hike. We remain positive on the safe-haven Japanese yen as a hedge with limited downside. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: GDP growth increased to 1.3% year-on-year in Q2. On a quarter-on-quarter basis however, GDP growth contracted by 0.2% in Q2. Current account deficit narrowed to £25.2 billion in Q2, from £33.1 billion in Q1. Nationwide house prices grew by 0.2% year-on-year in September, compared with 0.6% in August. Markit manufacturing PMI increased to 48.3 in September from 47.4; Construction PMI fell to 43.3 from 45; Services PMI fell below 50 to 49.5. GBP/USD increased by 0.8% this week. PM Boris Johnson gave a speech this week and introduced the details of a Brexit proposal that was an easy target for the firing squads in this imbroglio. Another Brexit delay and re-election seem highly likely. The improvement in the Markit manufacturing PMI reflects higher confidence over the lower probability of a hard Brexit in our view. We recently upgraded the outlook for U.K. and went long the GBP/JPY. Stay with it.  Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Headline inflation slowed from 1.7% to 1.5% year-on-year in September. Private sector credit grew by 2.9% year-on-year in August. AiG manufacturing PMI increased to 54.7 in September from 53.1 in August. AiG services PMI marginally increased to 51.5 from 51.4. Commonwealth manufacturing PMI fell slightly to 50.3, from an upward-adjusted 50.9 in August. Commonwealth services PMI was little changed at 52.4. Building permits keep contracting by 21.5% year-on-year in August. Exports fell by 3% month-on-month in August, while imports were unchanged. The trade surplus narrowed to A$5.9 billion from A$7.3 billion. AUD/USD fell by 1.3% initially post RBA, then recovered with broad U.S. dollar weakness, returning flat this week. The RBA lowered interest rates by another 25 basis points on Tuesday, and stated that “the Australian economy is at a gentle turning point.” Lower rates, though not fully transferred to mortgage rates, could help to stabilize the housing market to some extent, and lift wage growth. We maintain a pro-cyclical stance and remain positive on the Australian dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: Building permits increased by 0.8% month-on-month in August. Activity outlook fell by 1.8% month-on-month in September. Business confidence fell further to -53.5 in September, from -52.3 in August. NZD/USD increased by 0.3% this week. The latest Quarterly Survey of Business Opinion, conducted by the New Zealand Institute of Economic Research, has shown that business conditions point to further slowing in economic activity. The manufacturing sector remains the most problematic. Moreover, firms are cautious about expanding, due to the combination of intense cost pressures, and weak pricing power. Australia has lowered interest rates giving ammunition to their antipodean neighbors to follow suit. The probability of rate cuts by RBNZ in its next policy meeting on November 13th reached 100%: 90% for a 25 bps cut and 10% for 50 bps. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: On a month-on-month basis, the GDP stagnated in July. On a year-on-year basis, GDP growth slowed from 1.5% to 1.3% in July. Markit manufacturing PMI increased to 51 in September, from 49.1 in August. Bloomberg Nanos confidence increased to 57.8 for the week ended September 27th. Raw material prices fell by 1.8% month-on-month in August. USD/CAD increased by 0.5% this week. Canadian GDP growth in July was led by the services sector. The divergence was 2.5% year-on-year in July for services GDP, while goods GDP continued to deteriorate, contracting by 1.8% year-on-year. GDP in the energy sector, a focal industry in the country, fell by 3.4% year-on-year in July, affected by the fluctuations in oil prices. Moreover, as our colleagues in Commodity & Energy Strategy point out, the price differential between Canadian crude oil and WTI would likely to deepen further, possibly reaching a discount of $20/bbl into 1Q20, due to transportation constraints in the west. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 93.2 in September. Real retail sales contracted by 1.4% year-on-year in August. Manufacturing PMI fell to 44.6 in September from 47.2 in August. Headline inflation decreased to 0.1% year-on-year in September, from 0.3%. USD/CHF increased by 0.7% this week. While the Swiss economy is highly linked to global developments, especially those in the euro area, the positive current account balance makes it less vulnerable on a relative basis. We continue to favor the franc as a safe-haven hedge. We discuss the franc in this week’s front section. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There are scant data from Norway this week: Retail sales were unchanged in August. USD/NOK appreciated by 0.3% this week. The recent decline in oil prices has pushed our petrocurrency basket trade offside, weighed by the quick oil facility recovery in Saudi and demand concerns over a possible recession. That said, we continue to overweight energy prices and the Norwegian krone. The looming tension in the Middle East could lead to further escalation, which will again disrupt oil supplies and lift oil prices.  Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Retail sales grew by 2.7% year-on-year in August, compared to a 3.9% yearly growth in July. Manufacturing PMI plunged to 46.3 in September, from 52.4 in August. USD/SEK increased by 0.5% this week. While the PMI employment component increased to 52.4 from 51.9, the new orders index plunged below 50 to 45.8. The new orders-to-inventory ratio also continues to decrease, which usually leads the euro area manufacturing PMI by a few months. This is one of the key data points we follow, so are heeding to the message from this indicator. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming Chart 2Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low?   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation

Highlights The fundamentals of the U.S. economy remain strong but investors’ skittishness has caused stocks to fluctuate with the ebb and flow of news headlines. With investor sentiment playing a leading role, we introduce a simple framework for tracking the course of animal spirits. Earnings expectations are undemanding, risk appetite remains robust and the monetary policy backdrop is supportive of the expansion. However, geopolitical unpredictability and potential irrational exuberance send warning signals. We continue to believe that recession worries are overblown, but there is no rule that says bear markets can only occur alongside recessions. Although there are some areas of concern, our overall assessment of other potential bear market triggers does not suggest that trouble is at hand. Feature A bear can find plenty to worry about these days. The trade war is still casting a shadow over global trade prospects, global manufacturing activity is slowing, the U.K. and German economies contracted in the second quarter and recent attacks demonstrated that Middle Eastern oil facilities were more vulnerable than investors realized. The R-word has abounded in the financial press all summer and the number of Google searches for the term “recession” surged to levels last reached in the months leading to the Great Financial Crisis. The summer anxiety did not last, though. Powered by a perceived cooling of trade tensions and monetary support from the Fed, the S&P 500 has already recouped all of its summer losses. The market swings were not driven by the domestic macroeconomic backdrop, which remained largely unremarkable. The U.S. economy is slowing after 2018’s sugar rush, but is still getting enough fiscal support to grow at or above trend despite the global slowdown. To this point, the slowdown has been confined to manufacturing, and the history of past industrial production cycles suggests it has almost run its course. The service sector is resilient across the developed world and the fundamentals for U.S. consumption remain strong. Fundamentals are not the whole story, however, and they have lately taken a backseat to politicians’ whims. The resulting anxiety has made it relatively easy to surpass downwardly revised expectations (Chart 1), and we have little concern that the bottom is about to drop out of S&P 500 earnings. But earnings are only half of the equation. The multiple investors are willing to pay for those earnings is the other half, and they could be the key swing factor if earnings growth is going to remain in the low single digits. Chart 1Markets And Economic Data Are Out Of Sync We introduce a simple framework for tracking animal spirits. Multiples are largely a function of investor enthusiasm, and we attempt to track it via the Ex-Recession Bear Market Checklist developed by our sister Global ETF Strategy service (Table 1). It seeks to measure animal spirits across six dimensions: expectations, prices, appetite, euphoria, policy and geopolitics. Constructing the checklist is necessarily subjective, and as such we consider it a welcome complement to our fundamental analysis. We remain deeply invested in searching out the coming equity market inflection point, and delving into animal spirits allows us to track a wider range of potential catalysts. Table 1Ex-Recession Bear Market Checklist Expectations Chart 2Back To Sustainable Levels... After calling for unusually strong late-cycle profits growth last year on the back of the cut in corporate tax rates, earnings expectations are undemanding relative to history (Chart 2). Consensus S&P 500 earnings estimates for the full year project just 1.5% growth over 2018. As of the beginning of last week, analysts had penciled in a 3% year-over-year decline in 3Q earnings for the S&P 500. Those estimates are likely to be revised even lower as corporations make sure they’ve underpromised in the final two weeks before 3Q earnings season kicks off. Perhaps the consensus is a bit too conservative. Even though the year-over-year benefits of corporate tax cuts are gone, the dovish pivots by the Fed and other major central banks will support earnings growth. In the U.S. in particular, where the economy is still strong, easier financial conditions should help extend the shelf life of the current expansion through 2020. Bottom Line: Earnings growth is not going to blast higher, but profits are unlikely to contract as long as the Fed continues to support the expansion. The earnings bar has been set very low, and it will be rather easy for S&P 500 companies to exceed it. Prices We keep close tabs on valuation metrics, though we try not to get too wrapped up in them. Expensive (cheap) stocks can get more expensive (cheaper) as investors can remain irrational for a while. Valuations only become prone to mean-revert when they reach extreme levels. Chart 3Restored Normal Mirror-Image Relationship Forward multiples offer greater insight when considered in conjunction with forward earnings estimates. It is unusual for both earnings estimates and forward multiples to be extended at the same time, as they were in 2018, because investors are typically unwilling to pay high multiples when they suspect that earnings may be peaking. The more normal mirror-image relationship has restored itself this year, as projected earnings growth has slipped below its mean level, balancing out the above-mean forward multiple (Chart 3). Chart 4Definitely Elevated, But Not Problematic Yet   Other conventional valuation measures remain elevated but valuations within one standard deviation of the mean are far from extreme (Chart 4). The S&P 500 price-to-sales ratio is the only metric nearing the two-standard-deviation level that marks what we view as the beginning of extreme territory. It is worth noting valuations have only eroded modestly in the current global geopolitical backdrop. Though they slid in the wake of the first tariff announcement, they have mostly recovered and have seemed somewhat inured to subsequent escalations, which may suggest that investors are becoming complacent about trade threats. Bottom Line: Stocks are fully priced and the fact that valuations were only modestly affected by tariff uncertainty has gotten our attention. One-sigma deviations do not point to an immediate reversal, however, so we will wait for more metrics to approach the two-sigma threshold before raising a red flag on valuations. Appetite IPO activity is a proxy for animal spirits. Well-received IPOs are a sign that investors still have a hearty appetite for what the future might hold and suggests that they do not fear the imminent end of the bull market. If new issues are too well received, however, IPO appetite becomes a contrary indicator. When an IPO frenzy takes hold, it’s a sign that optimism has reached unsustainable levels and the end of the cycle must be near. For now, we judge that the IPO market is healthy but not too healthy. Chart 5Improved Corporate Health Or Heightened Risk Appetite? We consider it healthy that the number of IPO deals has remained stable since 2017, though the fact that their average value has more than doubled over that time could be a sign that investors are willing to grant increasingly higher values to private and newly-public companies (Chart 5). The fact that a steadily increasing share of the companies commanding larger valuations have yet to turn a profit is somewhat unsettling (please see the “Euphoria” section, below). We are therefore encouraged that investors pushed back so vigorously against the IPO of We Work’s parent company. Media reports suggesting that the sub-lessor of office space may be valued around a quarter of management’s initial estimates indicates that institutional investors are not blindly chasing the next hot deal. The companies that have completed offerings this year have fared well. 60% of the U.S. companies that have gone public so far this year are trading above their initial offering price. The median “successful” IPO in 2019 has returned 50% since inception, while the median “unsuccessful” IPO lost 23%. This asymmetry and the larger number of “successful” IPOs suggests that IPOs continue to be generally well-received. Bottom Line: Investors’ appetite for new issues has held up despite a challenging geopolitical and global growth backdrop, while We Work’s struggles to attract a public ownership base suggests they have maintained some healthy skepticism. As it relates to the near-term outlook, we rate investor appetites as light green. Euphoria IPO activity can also offer a window into investor euphoria. The share of companies going public with negative earnings has reached levels last observed in the years preceding the dot-com crash. The fact that profitless IPOs are currently better received by investors than IPOs of profitable companies is a concern (Chart 6). Chart 6Getting Carried Away While we noted that aggregate S&P 500 valuations are within normal ranges, valuations among the most highly valued stocks suggest that some exuberance has broken out. Using the backtest functionality of BCA’s Equity Trading Strategy platform,1 we devised baskets of the top deciles of stocks ranked by Price-to-Earnings, Forward Price-to-Earnings, Price-to-Tangible Book Value, Price-to-Sales and Price-to-Operating Cash Flow. Chart 7The Most Expensive Stocks Are Getting More Expensive The rising median P/E ratio of the top-decile P/E stocks suggests that investors continue to support the highest valuations by piling into the most richly valued firms. The same pattern prevails for the top deciles of stocks ranked on the four other multiples (Chart 7). Four out of the five metrics we track are now at or above two standard deviations from their mean. Bottom Line: Demand for unprofitable companies’ IPOs and the extreme valuations of the highest-valued companies on a range of metrics suggest that investors have gotten a little carried away. We rate this dimension orange. Policy We previously noted that restrictive monetary policy has been a precondition for every recession in the last 50 years. Consistent with its repeated pledge to sustain the expansion as long as possible, the Fed delivered its second rate cut earlier this month, and central banks around the world have embarked on what is turning into a synchronized dovish pivot. Despite unanimous expectations of easier policy at its September meeting, the ECB managed to surprise somewhat dovishly with the announcement of an open-ended bond purchase program, dubbed “QE Infinity”. Other developed-economy central banks like the already accommodative Reserve Bank of New Zealand have been delivering dovish surprises in the form of larger-than-expected rate cuts. Bottom Line: Uber-dovish U.S. and global central banks should prolong the shelf life of the expansion. Geopolitics The U.S.-China trade war continues to loom as the biggest risk to the global economy and the main source of investor angst. The Iranian attack on critical Saudi Arabian infrastructure also has the potential to destabilize markets and exacerbate investor concerns. Our Geopolitical Strategy service could see U.S.-China tensions receding in the near term, but fear that Iran will be an ongoing irritant. The motivations on the U.S. side are straightforward: first and foremost, the current administration wants to be re-elected next November. It is way too early to call the election – we won’t know who will face off until next summer – but one ironclad law of presidential elections is surely on the administration’s mind. The incumbent party always loses the White House if a recession occurs during the campaign (Chart 8). If hard-nosed trade policy appeared to be pushing the economy in the direction of a recession, it is likely the administration would dial down its aggressiveness. Chart 8A 2020 Recession Is The Biggest Threat To Trump's Reelection Prospects Enter the Iranians. Their (apparent) attack on critical Saudi oil facilities2 signals that Middle Eastern tensions could intensify and crude prices could blast higher. As we wrote last week, the U.S. economy is far less exposed to an oil price shock than it was in the ‘70s, due mainly to its emergence as the world’s largest oil producer, but the rest of the world is vulnerable. An oil price shock could induce a global ex-U.S. recession. The U.S. is a comparatively closed economy, and it regularly responds to global forces with a longer lag than other economies. It does eventually respond to them, however, and if an oil price shock leads to recessions in major economies in the rest of the world, it will ultimately threaten the U.S. economy. Keeping the expansion going through November 2020 may require U.S. policymakers to focus carefully on the Middle East to defuse the potential implications of Iranian belligerence. The administration may need to cool tensions with China to free up the bandwidth to deal with Iran, and also to prevent trade tensions’ marginal pressure on global growth from making the global economy more vulnerable to an oil price spike. Our overall assessment of bear market triggers does not suggest that trouble is imminent. The U.S.-China pause our geopolitical colleagues have been calling for would not be as beneficial for markets as a holistic trade settlement, but it appears to be materializing. In deference to China’s National Day celebrations, the U.S. will delay the tariff hike that was supposed to begin October 1st (from 25% to 30% on $250 billion worth of Chinese imports). China, for its part, has issued waivers for tariffs and promised to increase purchases of U.S. farm goods. A trade deal with Japan has also been agreed in principle and is slated to be signed any day, while U.S. relations with Europe are marginally improving.3 Bottom Line: The latest pause in trade tensions is boosting investor sentiment and risk-asset performance but the unpredictability of the current administration’s actions and public communications still have the potential to rattle markets. We rate this dimension orange. Investment implications We continue to believe that worries of a recession are overblown, but it might also take time for investors to overcome all of their concerns. A lot of fear is already discounted in the 2019 earnings estimates correction, bringing the bar quite low for corporate earnings to beat expectations. Coupled with an accommodative policy backdrop and still-robust investor appetites, the expansion still has room to run. Equities are not a slam dunk at this point in the cycle. Valuations are full, global growth is uncertain, and geopolitics are a wild card. Volatility is likely to be elevated and subject to sporadic spikes. We remain positive on the U.S. economy and continue to expect global growth will pick up later this year, however, so we continue to recommend that investors remain at least equal weight equities in balanced portfolios.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Available at https://ets.bcaresearch.com/ 2 Abqaiq is the most important oil-processing facility in the world, and the Khurais oil field is adjacent to the Ghawar oil field, the world’s largest. 3 Please see BCA Research Geopolitical Strategy Weekly Report “Trump’s Tactical Retreat”, published September 13, 2019. Available at gps.bcaresearch.com.

Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long.  The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed.  In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July.  The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July.  Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading  partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights U.S. growth will soon rebound thanks to robust drivers of domestic activity, and strengthening money and credit trends. The U.S. Federal Reserve will maintain an easing bias and will expand its balance sheet again. A growing Fed balance sheet will catalyze an underlying improvement in global liquidity conditions and boost the global economy. Brexit, China and Iran are key risks. The dollar will depreciate, bond yields will rise further and silver will outperform gold. Equities will surpass bonds on both cyclical and structural investment horizons. Financials and energy are more attractive than tech and healthcare. Thus, Europe is becoming increasingly appealing relative to the U.S. Feature Global equities are only 5% below their January 2018 all-time highs and the S&P 500 is close to breaking out above its July 2019 record. Meanwhile, yields are rebounding and value stocks are crushing momentum plays. Are these trends durable? Global growth is the key. If economic activity around the world can stabilize and ultimately improve, then stocks will break out and bond prices will suffer in the coming year. Otherwise, these recent financial market developments will undo themselves. Even if current activity remains weak, the outlook for global growth is looking up, despite trade wars, Brexit, Middle East tensions and problems in the interbank market. Therefore, we continue to favor stocks over bonds, because the backup in yields has further to go. If the dollar weakens, our pro-risk stance will only strengthen. U.S. Growth Drivers Are Healthy Chart I-1Recession Indicators Are Flashing A Yellow Flag The U.S. is near the end of a potent mid-cycle slowdown, but a recession will be avoided. Current conditions support an improvement in U.S. activity next year, even if key recessionary indicators, such as the yield curve and the annual rate of change of the Leading Economic Indicator, are still sending muddy signals (Chart I-1). U.S. growth will intensify because of five fundamental factors that will ultimately push the LEI higher and force the yield curve to re-steepen: A budding housing rebound, robust household spending, a stabilizing manufacturing sector, limited inflationary pressures, and a pick-up in money and credit trends. Housing The housing market has stabilized, buoyed by strong household formation, decent affordability, passing of the shock created by the cap in state and local tax deductions, and a 110-basis point collapse in mortgage yields since November 2018. Housing market indicators are finally catching up with leading variables, such as mortgage applications. In the past nine months, the NAHB housing market index has recovered nearly two-thirds of its decline since December 2018. Building permits and housing starts are at their highest levels since 2007, despite a significant fall last year. Even existing home sales have increased by 11% since December and are tracking the stimulation offered by lower borrowing costs (Chart I-2). Chart I-2The Housing Recovery Is Real Residential investment should soon boost economic activity after curtailing the level of GDP by 1% over the past six quarters. Moreover, rebounding housing activity implies that policy is not constraining growth. The real estate sector is historically the most sensitive to monetary conditions. Households Are Still Doing Well Core U.S. real retail sales continue to grow at a more than 4% annual pace and the Atlanta Fed GDPNow model forecasts a healthy 3.1% annual rise in consumer spending in the third quarter. This resilience is particularly impressive in the face of economic uncertainty and an ISM Manufacturing index below the 50 boom-bust line. Strong balance sheets are crucial to households. After 12-years of deleveraging, household debt has contracted by 37 percentage points to 99% of disposable income. Consequently, debt-servicing costs only represent 10% of disposable income, the lowest level in more than 45 years. Moreover, the household savings rate is a healthy 7.9% of after-tax income, which is particularly high in the context of the highest net worth ever and the lowest debt-to-asset ratio since 1985. Household income creates an additional support to consumption. Real disposable income is expanding at a 3% annual rate, despite slowing job creation. A tight labor market explains this apparent paradox. The employment-to-population ratio for prime-age workers is our favorite measure of labor market slack, and it has escalated to 79.7%, a level consistent with the 2.9% pace of annual growth in wages and salary (Chart I-3). The UAW strike at GM, the quits-rate at an 18-year high, and the difficulties small firms face to find qualified workers, all suggest that wages (and thus, consumption) will remain well underpinned (Chart I-3, bottom panel). Improving Manufacturing Outlook Manufacturing activity is set to rebound, despite the weakness in the ISM Manufacturing index. Recent industrial production numbers have already improved. Monthly IP expanded at a 0.6% monthly pace in August, but as recently as April, it was shrinking at a -0.6% rate. U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The car sector will soon bottom. Weak auto production has been a primary diver of the recent global manufacturing slowdown. The automotive component of GDP contracted at a stunning 29.1% annual rate in the second quarter. However, U.S. light-vehicle sales are essentially flat. This dichotomy implies that the automobile sector’s inventories are contracting briskly (Chart I-4). Chart I-3A Tight Labor Market Supports Consumption Chart I-4Will Auto Production Rebound Soon?   Capex should also recover. Last quarter, investment in structures and equipment subtracted from GDP growth. Before this, capex intentions had fallen significantly, now, the Philly Fed’s capital expenditure component is trying to stabilize. Capex must stop falling if global manufacturing is to strengthen. Limited Inflationary Pressures Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued expansion. Secondly, low inflation keeps real income growth higher and increases the welfare of households. At 2.4%, core CPI is perky, but will soon roll over. Core goods prices have been driving fluctuations in aggregate core prices in the past three years, while service sector inflation has been stable at 2.7% during this period. Goods inflation will soon weaken for the following reasons: Chart I-5The Trade War Is Masking The Economy's Deflationary Tendencies Soft global economic activity will drive down global inflation. Inflation lags real activity and proxies for the global economy, such as Singapore’s GDP, point to weaker core CPI in the OECD (Chart I-5). This weakness will act as a drag on U.S. inflation because U.S. goods prices have a large international component. U.S. import prices peaked 15 months ago and they normally lead goods inflation by roughly a year and a half. The strength in the broad trade-weighted dollar, which has climbed by nearly 15% in the past 18 months to an all-time high, will hurt goods prices. U.S. capacity utilization declined through 2019 and remains well below the 80% level that historically causes core goods prices to overheat. The White House’s tariffs on China are boosting inflation but this effect will prove transitory. The tariffs are pushing up inflation for goods touched by the levies, while unaffected goods are experiencing deflation (Chart I-5, bottom panel). Given that tariffs have a one-off impact and that inflation expectations are hovering near record lows, inflation for tariffed-goods will converge toward the underlying trend in non-tariffed goods. Stronger Money And Credit Trends Money and credit trends indicate that the recent slump will not translate into a recession. Moreover, improving U.S. private-sector liquidity conditions argues that the mid-cycle slowdown is ending. Chart I-6Liquidity Indicators Point To A Growth Rebound U.S. broad money is recovering. After falling to 0.9% last November, U.S. real M2 growth is expanding at a 3% annual rate, a pace in keeping with the end of mid-cycle slowdowns. Moreover, money is also accelerating relative to credit issuance, which historically has pointed to quicker industrial activity. Similarly, our U.S. financial liquidity index is rapidly escalating, a development that normally precedes turning points in the ISM manufacturing (Chart I-6) index. Credit activity is also picking up. Corporate bond issuance is firming and, according to the Fed’s Senior Loan Officer Survey, demand for loans is rebounding across the board. The yield collapse is boosting credit growth across the G-10. Gold is outperforming bonds, which confirms that a mid-cycle slowdown occurred. If inflation is not a problem, then the yellow metal always underperforms bonds ahead of recessions. However, before mid-cycle slumps, gold consistently outperforms bonds (Chart I-7). Chart I-7Bonds Outperform Gold Ahead Of Recession More Fed Easing Imminent U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The Fed will ease policy further and is a long way from tightening. Last week, the Federal Open Market Committee (FOMC) curtailed the fed funds target rate by 25 basis points to 2%. Additionally, while the median projection shows that Fed members expect no more rate cuts for at least the next 18 months, the reality is more subtle. Among 17 FOMC members, 7 expect to cut the fed funds rate by another 25 basis points by year end, and 8 foresee a lower policy rate in late 2020. The greenback is very expensive and will decline as global liquidity conditions improve. We are still on track for three 25-basis-point rate cuts this year. The Fed remains highly data dependent and is particularly sensitive to depressed inflation expectations. This means the Fed is acutely aware of the danger created by a sudden tightening in financial conditions. If by year-end the market has not moved away from discounting another cut in 2019, the FOMC will likely deliver this easing. Otherwise, financial conditions could suddenly tighten, which would hurt inflation expectations and the economic outlook. If global growth does not recover in early 2020, the Fed would probably cut rates an additional time in the first quarter, which would validate the current 12-month pricing in the OIS curve. Chart I-8Not Enough Excess Reserves The Fed will again increase the size of its balance sheet. Interbank markets have boxed the FOMC into adding welcomed stimulus to the global economy. Allowing commercial bank excess reserves to grow anew will have a greater positive impact for global growth compared with rate cuts alone. Last month, we highlighted the risks to the repo market created by the combination of the dwindling of excess reserves, the bloated securities inventory of primary dealers financed via repo transactions, and the growth in the issuance of Treasurys.1 These risks materialized last week, when the Secured Overnight Financing Rate (SOFR) suddenly spiked above 5% (Chart I-8). To calm the market, the Fed injected $75 billion each day last week starting Tuesday to bring repo rates closer to the Interest Rate on Excess Reserves (IOER). But this is not a long-term solution. Chart I-9Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Paradoxically, the crystallization of the repo market tensions is good news for the global economy because it will force the Fed to again expand its balance sheet as soon as next month. The supply of funds to the repo market needs to increase permanently, which means that banks’ excess reserves must re-expand. As we showed last month, higher excess reserves will hurt the U.S. dollar, lift EM exchange rates and boost global PMIs (Chart I-9). Higher excess reserves ease global liquidity conditions. The money injected will find its way to the rest of the world. The dollar trades 25% above its long-term, fair-value estimate of purchasing power parity. Therefore, a growing fiscal deficit indirectly financed by a larger Fed balance sheet will lead to a larger U.S. current account deficit, which in turn, will lift global FX reserves. As a result, the Fed’s custodial holdings of securities on behalf of other central banks will rise. Thus, global dollar-based liquidity will stop contracting relative to the stock of U.S. dollar-denominated foreign currency debt it supports (Chart I-10). Higher excess reserves will also ease global financial conditions. By boosting dollar-based liquidity, a larger Fed balance sheet will dampen offshore dollar interest rates. Moreover, rising excess reserves depreciate the greenback, which further cuts the cost of credit for foreign entities borrowing in U.S. dollars. This phenomenon is especially significant for EM. Therefore, we should see an easing of EM financial conditions, which are heavily dependent on EM exchange rates. Historically, looser EM financial conditions lead to stronger global growth (Chart I-11). Chart I-10High-Powered Liquidity Set To Improve Chart I-11Easier EM FCI Should Lead To Faster Growth   Risks: The U.K., China And Iran While the outlook generally points to a rebound in global growth, which will create a positive environment for risk assets, the situations in the U.K., China, and Iran should be closely monitored. The U.K. Brexit remains a potential danger for the world even though our base case calls for a benign outcome. U.K. Prime Minister Boris Johnson’s gambit to push for a No-Deal Brexit to force the EU to make concessions could result in a miscalculation. Such a turn of events would plunge a European economy – already damaged by weak global trade – into recession. The dollar would strengthen and global financial conditions would tighten. Global growth would take another hit. Chart I-12U.K.: No Clear Winner Ahead Of A Potential Election Following this week’s Supreme Court unanimous ruling against Johnson’s decision to prorogue Parliament, No-Deal carries a less than 10% probability. Johnson lacks a majority in a Parliament staunchly against a hard Brexit and he is unable to call an election prior to the October 31st deadline to leave the EU. Therefore, a delay is the most likely outcome, which will allow the EU and the U.K. to reach a deal on the Irish backstop that Parliament can then ratify. Ultimately, the U.K. needs another election to break the current logjam, which could materialize in November or December. However, the Remain vote is split between Labour, Lib Dems, and the SNP, but the Brexit vote is not nearly as divided. (Chart I-12). Hence, Brexit will remain a risk lurking in the background even if it does not morph into a full-blown assault on global growth. China Chart I-13Chinese Stimulus Remains Too Tepid To Move The Needle China’s economic activity continues to soften. In August, industrial production and fixed-asset investment decelerated to 4.4% and 5.5%, respectively. Moreover, total social financing growth slowed on an annual basis and overall Chinese credit flows decreased as a share of GDP (Chart I-13). Chinese policy reflation remains too tepid to undo the drag created by trade uncertainty and the weakness in the marginal propensity to spend (Chart I-13, bottom panel). Sino-U.S. trade tensions have significantly decreased in recent months, but they will remain an important source of uncertainty for China and the world. China and the U.S. will again hold high-level talks next month, U.S. President Donald Trump has again postponed some of the tariff increases, and China is again buying mid-Western soybeans and pork. But last Friday’s cancelation of U.S. farm visits by Chinese officials reminds us that the situation is very fluid. Ultimately, China and the U.S. are long-term geopolitical rivals. Trump may be constrained by the 2020 election, but China could still drive a hard bargain. Hence, it is prudent to expect a stop-and-go pattern in the negotiations. Chart I-14Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs A weak China will sow the seeds of its own recovery. In addition to the negative effect on capex intentions and credit demand of trade uncertainty, Beijing faces deteriorating employment and producer price inflation of -0.8% (Chart I-14, top panel). As PPI inflation becomes more negative, heavily indebted corporate borrowers face rising real interest rates (Chart I-14, bottom panel). This higher cost of debt weakens an already vulnerable economy, unleashing a vicious circle. Chinese policymakers are unlikely to tolerate this situation for much longer. The cumulative 400-basis point cuts in the reserve requirement ratio since April 2018 are steps in the right direction, but are not yet enough. The dovish change to the Politburo’s and State Council’s language indicates that greater stimulus is forthcoming. Thus, credit expansion, local government special bonds issuance and fiscal stimulus will become even more prevalent in the final quarter of 2019. This policy should noticeably goose economic activity in 2020, which will help global growth accelerate. Iran Tensions are re-flaring and a spike in oil prices would threaten the fragile global economy. However, this remains a risk, not a central case. In the July issue of The Bank Credit Analyst, we warned that tensions with Iran were the greatest visible risk to global growth and risk assets.2 This danger came into focus last week with the drone attacks on the Khurais oil field and Abqaiq oil processing facility in Saudi Arabia, which curtailed global oil supply by an unprecedented 5.7 million bbl/day, or 5.5% of global demand. Unsurprisingly, Brent prices quickly surged by 12% to $68/bbl. Chart I-15Higher Energy Efficiency Makes The World More Robust A durable spike in oil prices would push the global economy into a recession, especially while the global economy is already on weak footing. Chief U.S. Equity Strategist Anastasios Avgeriou reminded his clients3 that according to a seminal 2011 paper by Prof. James D. Hamilton, a doubling of oil prices preceded all but one of the post-war recessions.4 However, an oil-induced recession would likely be shallow because the oil intensity of the global economy has significantly declined in the past 30 years (Chart I-15). Moreover, global fiscal authorities would respond forcefully to an economic contraction, which would also limit the impact of the shock. There is a low likelihood that oil will double by year-end. It would require Brent prices to surge to $100/bbl. Saudi Arabia has already stated that production will return to pre-crisis levels in the coming days and not a single shipment will be missed. This promise implies further inventory drawdowns. Aramco also expects to achieve maximum output by late November. Moreover, higher oil prices will encourage further activity in the U.S. shale patch. Consequently, oil prices are unlikely to surge by another $35/bbl in the next three months. However, Brent prices could climb to $75/bbl next year, because while oil demand is set to recover, investors must also embed a greater risk premium against Saudi supply disruptions. A military conflict with Iran is a tail risk, but if it were to materialize, crude prices would surge by $35/bbl or more in an instant. According to Matt Gertken, BCA’s Chief Geopolitical strategist, the appetite for such a conflict is low in the U.S.5 President Trump has isolationist instincts and does not want to be mired in another conflict. Investment Implications The Dollar The dollar has significant downside. The greenback is very expensive and will decline as global liquidity conditions improve (Chart I-16). These dynamics reflect the countercyclical nature of the dollar and also lead to strong greenback momentum, both on the way up and down. The dollar would weaken in response to improving global growth and liquidity conditions, the lower dollar would ease global financial conditions, further stimulating the global economy. A virtuous circle could then emerge. Chart I-16Increasing Financial Liquidity Will Hurt The Greenback Repatriation flows will also move from a tailwind to a headwind for the greenback. Prompted by both rising risk aversion and the Trump tax cuts, U.S. economic agents have repatriated $461 billion in the past 18 months. This has created powerful support for the USD (Chart I-17). The effect of the tax cut is vanishing and rising global growth will incentivize U.S. households and firms to buy foreign assets more levered to the global business cycle. In the process, they will sell the dollar. Chart I-17Repatriation Will Not Support The Dollar For Much Longer The euro will continue to behave as the anti-dollar, a consequence of the pair’s plentiful market liquidity. Moreover, the euro trades at a 17% discount to its purchasing power parity equilibrium. After last week’s rate cut and QE announcement, the European Central Bank has no more room to ease. Instead, the recent fall in peripheral bond spreads is loosening European financial conditions, which is boosting European growth prospects. This makes the euro more attractive. Bonds And Precious Metals Safe-haven yields will have significant upside in the coming 12 to 18 months. As we highlighted last month, bonds are so expensive, overbought and over-owned that they suffer from an extremely elevated probability of negative cyclical returns (Chart I-18, left and right panels). Moreover, excess reserves will once again grow when the Fed re-starts to expand its balance sheet. Higher excess reserves lead to a steeper yield curve slope (Chart I-19). Short rates have limited downside, therefore, the curve can only steepen via higher 10-year yields. Chart I-18AValuation And Technicals Point Toward Higher Yields In 12 Months (I) Chart I-18BValuation And Technicals Point Toward Higher Yields In 12 Months (II)   Chart I-19Fed Purchases Will Steepen The Curve Short-term dynamics are more complex. Treasury yields have climbed by 21 basis points since their September 3rd low, mostly on the back of decreasing trade tensions. In previous mid-cycle slowdowns, bond price tops only emerged after the ISM bottomed. We are not there yet. We expect substantial short-term volatility in yields in view of the unpredictable Sino-U.S. negotiations and the current lack of pick-up in global growth. During this transition process, cyclical investors should use bond rallies such as the current one to build below-benchmark duration positions in their fixed-income portfolios. Within precious metals, we continue to prefer silver to gold. We have favored precious metals since late June,6 but higher bond yields are negative for gold. However, central banks are maintaining a dovish bias aimed at lifting inflation breakevens back to their historical norm of 2.3% to 2.5%. This process increases the chance that the economy will overheat late next year. For the next 12 months, rising inflation expectations, not higher real rates, will push up bond yields. Combined with a weaker dollar, this configuration is mildly bullish for gold. Silver has a higher beta and more industrial uses than gold, which will allow for a period of outperformance if global growth increases. In this context, the silver-to-gold ratio, which stands at its 6th percentile since 1970, is an attractive mean-reversion play (Chart I-20). Chart I-20The Silver-Gold Ratio Is A Bargain Equities Investors should continue to favor stocks relative to bonds in the next year. Equities perform well up to six months before a recession starts (Table I-1). Moreover, our monetary and technical indicators are upbeat (see Section III). Additionally, sentiment surveys do not show rampant investor complacency (see Section III), which limits risks from a contrarian perspective. Meanwhile, yields have upside, which implies an outperformance of stocks versus bonds. Table I-1The S&P 500 Doesn’t Peak Until Six Months Before A Recession The short-term picture is more complex. P/E ratio expansion powered 90% of the S&P 500’s gains since it bottomed in December 24, 2018, and according to our model, U.S. operating earnings will contract for at least eight more months (Chart I-21). Thus, if yields mount through the rest of the year, multiples will likely contract. The S&P 500 is set to continue to churn over that time frame. Chart I-21U.S. Profits Still Have Downside In this context, strategy dictates investors focus on internal stock market dynamics. Namely, investors should favor financials and energy at the expense of tech and healthcare for the following reasons: Rising bond yields lift financials’ net interest margins. They also hurt multiples for tech stocks, which carry a large percentage of their intrinsic value in long-term cash flows and their terminal value. Thus, rising yields correlate with an outperformance of financials relative to tech (Chart I-22). Moreover, financials’ valuations and technicals are very depressed relative to tech, while comparative earnings estimates are equally morose (Chart I-23). Finally, our U.S. Equity Strategy team expects buybacks by financials to increase significantly.7 Chart I-22If Yields Rise, Financials Will Beat Tech Chart I-23Valuations, Technicals And Sentiment Favor Financials Over Tech     Rising yields also hurts healthcare stocks. Additionally, the rising popularity of Democratic progressives like Senator Elizabeth Warren requires investors embed a risk premium in the price of healthcare stocks (Chart I-24). The progressives want to nationalize healthcare insurance and compress healthcare profit margins, from drugs to hospitals. Chart I-24The Rise Of The Progressives Requires A Risk Premium In Health Care Stocks We have used energy stocks as a hedge against rising tensions in the Middle East. Now, our U.S. Equity Strategy colleagues have become more positive on this sector. Energy valuations and technicals are very attractive relative to the S&P 500 (Chart I-25).8 Energy stocks will outperform if global growth recovers and lifts global bond yields These sectoral recommendations argue investors should soon begin to favor European relative to U.S. stocks. Financials and energy are overrepresented in European equities while tech and healthcare are large overweight’s in the U.S. (Table I-2). Moreover, European activity is more sensitive to global economic momentum than the U.S. Thus, when global yields rally and the world economy stabilizes, European stocks will outperform their U.S. counterparts (Chart I-26). Additionally, European banks trade at 0.6-times book value which makes them the ultimate value play, one highly geared to easier European financial conditions and higher yields. Chart I-25Energy Is A Compelling Buy Table I-2Overweighting Europe Is Consistent With Our Sectoral RecommendationsChart I-26Europe Will Soon Outperform The U.S. Chart I-27Long-Term Investors Should Favor Stocks Over Bonds These sectoral biases are also consistent with value stocks outperforming growth equities. However, as Xiaoli Tang from BCA’s Global Asset Allocation service argues in Section II, the value-versus-growth question is a complex one that needs to be differentiated across geographies and equity size. Finally, long-term investors should also favor stocks over bonds. According to BCA Chief Global Strategist Peter Berezin, global stocks at their current valuations offer an expected 10-year real return of 4.2%. By historical standards, these are not elevated returns, but they are still much more generous than government bonds. Based on their dividend yields, U.S., Japanese and European equities need to fall by 18%, 28% and 40% before underperforming bonds on a 10-year basis, respectively.9 This is a large margin of safety (Chart I-27). We prefer foreign stocks with their more attractive valuations and local-currency expected returns. Additionally, the dollar is expensive and will weaken in a 5- to 10-year investment horizon. Mathieu Savary Vice President The Bank Credit Analyst September 26, 2019 Next Report: October 31, 2019   II. Value? Growth? It Really Depends! Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.10 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,11 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,12 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”13 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.14 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.15 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”16 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Chart II-2BLarge-Cap Value-Growth Portfolios*   The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart II-5. Chart II-5Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.17 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Chart II-6BIs Value Dead In EM?   The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.18 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* Chart II-7BRussell Pure Styles*   For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally   Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,19 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.20, 21  This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* Chart II-10Prefer Sector And Country Positioning To Style We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President Global Asset Allocation III. Indicators And Reference Charts The S&P 500 will continue to churn this year. U.S. stocks have rebounded sharply through the month of September, yet, sentiment is neutral. Nonetheless, for now, stocks are likely to find it hard to meaningfully break above their July highs. Short-term momentum oscillators are overbought and U.S. profits still have downside. Because this year’s equity rally has been nearly entirely driven by multiples, this leaves equities vulnerable to any back-up in yields. As yields have not priced in any pick-up in growth, potential positive economic surprises are more likely to lift yields than stock prices. However, if growth disappoints, weak rates will cushion to blow to expected earnings. In line with this picture, our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields remain very depressed at highly stimulatory levels. Moreover, money growth has picked up around the world, and global central banks are cutting rates and expanding their balance sheets again. As a result, our Monetary Indicator remains at its most accommodative level since early 2015. Furthermore, our Composite Technical Indicator might not be improving anymore but it is still very much in constructive territory. Therefore, unlike four years ago, equities are more likely to avoid the headwind created by their overvaluation, especially as our BCA Composite Valuation index continues to improve.  10-year Treasurys may have cheapened a bit since last month, but they remain very expensive. Moreover, when current overvaluation levels are met by our technical indicator being as massively overbought as it is today, safe-haven bonds experience significant price declines over the following 12 months. That being said, the timing of a backup in yields is uncertain. If previous mid-cycle slowdowns are any guide, yields might need to wait for a bottom in the global manufacturing PMIs before rising freely. Nonetheless, the current setup argues against adding to long-duration bets. On a PPP basis, the U.S. dollar is only growing more expensive and the U.S. current account is deteriorating anew. For now, weak global manufacturing activity has helped the dollar stay well bid. However, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. This means that the dollar is highly vulnerable to any stabilization in growth. In fact, we would argue that the USD might prove to be the best variable to evaluate whether global growth is forming a durable bottom or not.   EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings   Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst Section I, “September 2019,” dated August 29, 2019, available at bca.bcaresearch.com 2       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 4              J. D. Hamilton, "Historical Oil Shocks," NBER Working Paper No. 16790. 5       Please see Geopolitical Strategy Special Report "Policy Risk, Uncertainty Cloud Oil Price Forecast," dated September 19, 2019, available at gps.bcaresearch.com 6       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 7       Please see U.S. Equity Strategy Weekly Report, “The Great Rotation,” dated September 16, 2019, available at uses.bcaresearch.com 8       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 11     Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 12     Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 13     Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 14      Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 15             Fama-French value-growth-size portfolios. 16     Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 17     Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 18     Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 19    Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 20     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 21     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.

Highlights Monetary Policy: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Money Markets & Fed Balance Sheet: Investors shouldn’t worry about last week’s chaotic action in money markets, and should pay less attention to the Fed’s balance sheet policy in general. Yes, the Fed will start growing its balance sheet again in the coming months, but this is much less important than what it decides to do with the fed funds rate. Global Economy: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course. Feature Chart 1Fed Dots Versus Market Expectations Fed Chairman Jerome Powell had his work cut out for him at last week’s FOMC press conference. First, he had to craft a coherent message about the Fed’s reaction function following a meeting where three voting members dissented from the committee’s decision to lower the funds rate by 25 bps. One dissenter, St. Louis Fed President James Bullard, wanted a 50 bps reduction. The other two, Boston Fed President Eric Rosengren and Kansas City Fed President Esther George, preferred to leave rates unchanged. Not only that, but Powell also had to field questions about the recent turmoil in money markets. Turmoil that caused the overnight repo rate to spike and the effective fed funds rate to briefly print outside the Fed’s target band (see section titled “Repo Madness” below). Chart 2Tracking Financial Conditions How did he perform? On all accounts we give the Chairman top marks. He managed to articulate a reaction function that didn’t commit to any near-term policy action, but most importantly, he did so in a way that prevented a sharp tightening of financial conditions. As we have argued in past reports, Chairman Powell’s most important job is to ensure that financial conditions remain accommodative so that the economic recovery can continue for long enough to bring long-dated inflation expectations back up to target.1 Chart 2 shows that, even after a tricky Fed meeting, financial conditions remain significantly more accommodative than they were earlier in the month: Credit spreads are tighter (Chart 2, panel 2) The yield curve has un-inverted (Chart 2, panel 3) TIPS breakeven inflation rates have widened (Chart 2, panel 4) The trade-weighted dollar has weakened (Chart 2, bottom panel) All this with only 7 out of 17 FOMC participants agreeing with the market’s assessment that one more 25 bps rate cut before year-end will be appropriate (see Chart 1). All in all, Powell did exactly what he needed to do. Investment Implications Table 1What's Priced In For The Rest Of 2019? As mentioned above, the market is priced for roughly one more 25 bps rate cut before the end of the year. More specifically, the fed funds futures market is split 50/50 on whether that rate cut occurs at the October or December FOMC meeting (Table 1). The market currently sees only a 4% chance of a rate cut at both meetings, and zero chance of no rate cut at all. We think the market’s view of the next two FOMC meetings is roughly correct, though we would not discount the possibility that global economic data improve enough that further rate cuts are avoided (see section titled “Still Searching For A Bottom” below). Ideally, the Fed wants the economic data to lead rate expectations higher so that it can avoid cutting rates without shocking the market and tightening financial conditions. Conversely, if the market starts to fully price-in an October rate cut in the next few weeks, then the Fed will likely deliver. This reaction function is extremely supportive for credit spreads, and we recommend sticking with an overweight allocation to spread product versus Treasuries. Chart 3Treasury Returns Track Rate Expectations As for portfolio duration, we continue to abide by our Golden Rule framework.2 If the Fed delivers less than the 57 bps of easing that the market expects over the next 12 months, then the Bloomberg Barclays Treasury index will likely underperform a position in cash (Chart 3). We see better odds of zero or one rate cut over that timeframe, and therefore recommend a below-benchmark duration stance. Bottom Line: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Repo Madness What Happened? Chart 4What Happened Here? As mentioned above, overnight U.S. interest rates spiked dramatically last week, grabbing headlines and causing many to question the stability of financial markets. The commotion peaked last Tuesday when the overnight general collateral repo rate closed at just under 7% and the effective fed funds rate ended the day above the upper limit of the Fed’s target band (Chart 4). Why Did This Happen? Chart 5Looking For The Culprit The turmoil’s proximate cause is that dealer banks found themselves short of cash. They therefore scrambled to borrow in money markets, driving overnight rates higher. Dealer banks were short on cash for a number of reasons. Many corporations withdrew funds to pay tax bills, and there was an unusually large amount of Treasury issuance in September, along with few redemptions (Chart 5). Dealer banks must purchase Treasury debt at auction, and of course require cash on hand to do so. But setting the proximate cause aside, the more important question is: Why don’t dealer banks have sufficient cash to weather such periods, which are bound to occur from time to time? The answer to this question has to do with the quantity of reserves being supplied to the banking system, which is ultimately a result of the Fed’s balance sheet policy. The Fed’s Balance Sheet & The Supply Of Bank Reserves Table 2Simplified Fed Balance Sheet Table 2 shows an abridged version of the Fed’s balance sheet as of last Wednesday, September 18. Notice that the Fed’s securities holdings appear on the asset side of the balance sheet, while the Fed’s liabilities include: (i) currency in circulation, (ii) the Treasury department’s cash account and (iii) bank reserves. Reserves are a liability on the Fed’s balance sheet, but appear as an asset on the consolidated balance sheet of the U.S. banking system. In other words, the banking system’s supply of liquid reserves is always equal to the Fed’s assets less the amount of currency in circulation and the Fed’s other “non-reserve liabilities”. Put simply, if dealer banks don’t have enough cash, it is because the Fed is not holding enough securities. Chart 6The Fed's Balance Sheet Over Time In fact, the Fed has been steadily draining the supply of bank reserves since 2014 (Chart 6). Initially, it did so passively by keeping its securities holdings constant and allowing reserves to decline by the amount of increase in currency-in-circulation and other “non-reserve liabilities”. Then, between October 2017 and July of this year, it actually shrank its portfolio, causing reserves to leave the system even more quickly. In August, the Fed returned to a policy of keeping its securities holdings constant, slowing the rate of decline in bank reserves.   It is also worth mentioning that the rate of decline in bank reserves was recently exacerbated by a sharp increase in the Treasury department’s cash holdings (Chart 6, bottom panel). The Treasury department needed to rebuild its cash balance after having run it down in advance of the last debt ceiling deadline. Like currency-in-circulation, the Treasury department’s cash holdings are a liability on the Fed’s balance sheet. All else equal, an increase in the Treasury’s cash holdings leads to a decline in the supply of bank reserves. Next Steps Chart 7The Fed's Floor System This year the Fed has been navigating through a process of “balance sheet normalization” where it seeks to reduce its asset holdings while still supplying enough bank reserves to ensure the effective operation of monetary policy. The Fed has already decided to operate monetary policy using a “floor system”, in contrast to the “corridor system” it employed prior to the financial crisis. In a corridor system, the Fed keeps the supply of bank reserves scarce, and then engages in daily repo transactions to ensure that it supplies just enough bank reserves to prevent the overnight rate from breaking through the top of its target range. In contrast, to operate a floor system the Fed must supply more reserves than the banking system demands. The excess supply of reserves forces the overnight rate down toward a floor set by the Fed’s overnight reverse repo facility (ON RRP). Essentially, the Fed sets the ON RRP rate at a level near the bottom of its target range, and pledges to pay that rate to any banks with excess cash (Chart 7). The fact that interest rates broke out above the top-end of the Fed’s target band last week suggests that the Fed is not supplying enough reserves to effectively operate its floor system. This means that we should consider the Fed’s “balance sheet normalization” process complete. In the coming weeks the Fed will roll out a plan to start growing its securities portfolio. It will do this by purchasing Treasuries with a maturity structure that roughly matches that of the outstanding debt load. The pace of Treasury purchases will either be set equal to the estimated rate of growth in non-reserve liabilities, a pace that would keep the supply of bank reserves flat and one that the Fed calls “organic growth”. Alternatively, the Fed might decide that the supply of reserves needs to rise for a time before leveling off. In that case, it would purchase Treasuries at a somewhat faster pace for a few months, before settling into an “organic growth” regime. The Fed will probably also roll out a standing repo facility in the coming months, with a rate set close to the upper-end of its target band. This will act as the mirror image of the current ON RRP, essentially capping the upside in interest rates by agreeing to lend overnight cash at a stated rate. The supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis.period  It will take at least a few weeks for the Fed to roll out its new balance sheet strategy and standing repo facility. In the meantime, the New York Fed will transact daily in the repo markets to ensure that enough reserves are supplied. This action represents a temporary return to a corridor system. Once the Fed starts growing its Treasury holdings again, it will be able to resume its floor system and the daily repo transactions will not be necessary. Some have probably already noted that the supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis period (see Chart 6). This is purely the result of the new post-crisis regulatory environment (see Box). Box - New Regulations Mean Banks Want More Reserves Two new regulations, specifically, have increased the amount of reserves that banks wish to hold. The first is the liquidity coverage ratio (LCR). The LCR mandates that banks hold sufficient high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves qualify as HQLAs, as do Treasury securities. Some other securities can also count as  HQLAs after a haircut is applied. While banks can opt to hold Treasuries instead of reserves and still maintain compliance with the LCR. A St. Louis Fed report from March showed that large U.S. banks are using reserves to cover 20% - 65% of their net outflows.3  The second relevant regulation is the resolution plan, or living will, that large banks are now forced to file with regulators. While the criteria here are more opaque, banks must demonstrate to regulators that they have enough short-term liquidity to cover demands from counterparties and other stakeholders in the event of material financial distress. Regulators likely put a greater emphasis on reserves than Treasury securities during such stress tests, since during a period of financial turmoil there may be doubts about how quickly a bank can convert a Treasury security into cash in the repo market.  Is This The Return Of QE? The answer really depends on how you want to define QE. If you want to call any increase in the Fed’s securities holdings QE, then yes the Fed will soon re-start QE. If you want to define QE as an expansion in the supply of bank reserves, then the Fed might briefly engage in QE for a few months, before reverting to an “organic growth” policy that keeps the reserve supply stable. In any event, unless you are active in money markets, we would advise investors to pay much less attention to the Fed’s balance sheet policy. The goal of its balance sheet policy is to ensure that interest rates remain within its target band, and the Fed will move that target band around independently of what is happening with its balance sheet. Changes in the Fed’s target interest rates are what matter for financial markets. Still Searching For A Bottom For reasons articulated in prior reports – notably, accommodative financial conditions and resolute service sector growth – we remain convinced that the current global manufacturing slowdown is near a trough.4 However, we must also point out that the 10-year U.S. Treasury yield tends to track the broad swings in the Global Manufacturing PMI, and a significant rebound in the 10-year yield is unlikely without a corresponding PMI upswing (Chart 8). Chart 8No PMI Rebound Yet... Chart 9...But Leading Indicators Are Hooking Up On that note, September Flash PMI data for the U.S. and Eurozone were released yesterday, and were at best a mixed bag. The Eurozone Manufacturing PMI fell from 47.0 in August to 45.6 in September (Chart 8, bottom panel) while its U.S. counterpart ticked higher from 50.3 to 51.0 (Chart 8, panel 3). In general, it is too early to say that the global PMI data have bottomed, especially with the CRB Raw Industrials index – a broad commodities benchmark – still in free fall (Chart 8, panel 2). Global Leading Economic Indicators paint a somewhat rosier picture than the PMIs. In fact, our Global LEI appears to have bottomed, and should eventually lead the Global PMI higher if prior correlations hold (Chart 9). We also observe that the U.S. economic data are once again beating expectations, an occurrence that usually corresponds with higher yields (Chart 9, bottom panel). In general, it is too early to say that the global PMI data have bottomed. Bottom Line: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2  Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3  https://www.stlouisfed.org/on-the-economy/2019/march/banks-demand-reserves-face-liquidity-regulations 4  Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?”, dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification