Monetary

Highlights Monetary Policy: The Fed is in no rush to tighten, and will remain on hold until inflation expectations or financial conditions give them a reason to resume hikes. Investors should take advantage by overweighting spread product while keeping portfolio duration low. Municipal Bonds: The best value in municipal bonds is found at the long-end of the Aaa-rated municipal bond curve. Lower-rated and shorter maturity munis are much less appealing. Investors should focus their municipal bond exposure on Aaa-rated debt with 20-year and 30-year maturities. Fed Balance Sheet: The Fed has now announced almost all the details of its balance sheet normalization plan. The Fed’s asset holdings will stop falling at the end of September, and we project that it will start buying securities again in 2020. Feature The minutes from the March FOMC meeting, released last week, were about as bullish for risk assets as anyone could have hoped. Not only did we learn that the Fed’s consensus forecast calls for economic growth to trough in Q1: Underlying economic fundamentals continued to support sustained expansion, and most participants indicated that they did not expect the recent weakness in spending to persist beyond the first quarter.1 But we also learned that, despite its economic optimism, the FOMC sees no reason to telegraph another rate hike any time soon: Chart 1Stay Overweight Corporate Bonds [A] majority of participants expected that the evolution of the economic outlook and risks to the outlook would likely warrant leaving the target range unchanged for the remainder of the year. The overall message couldn’t be clearer. The Fed is inclined to let the economy run for a while before it steps in to spoil the party. This supportive policy backdrop, coupled with our positive view of global growth,2 argues for investors to be overweight risk assets. Fortunately, even those who have so far been reluctant to add credit risk probably still have time to get in on the action. High-yield excess returns have only just made up the ground they lost near the end of last year, and investment grade corporates have another 46 bps to go (Chart 1). Further, only spreads from the highest rated credit tiers have tightened back to the target levels we set in February.3 Baa and junk-rated spreads still have ample room to tighten (Charts 2A & 2B). Specifically, The average Aaa-rated spread is currently 59 bps, 19 bps below our target. The average Aa-rated spread is currently 57 bps, exactly equal to our target. The average A-rated spread is currently 85 bps, 2 bps below our target. The average Baa-rated spread is currently 140 bps, 9 bps above our target. The average Ba-rated spread is currently 205 bps, 27 bps above our target. The average B-rated spread is currently 348 bps, 72 bps above our target. The average Caa-rated spread is currently 714 bps, 145 bps above our target. Chart 2AInvestment Grade Spread Targets Chart 2BHigh-Yield Spread Targets As a result, we recommend that investors avoid Aaa-, Aa- and A-rated credits, but overweight the remaining corporate credit tiers. Who’s Watching The Punch Bowl? Even though a hike is not imminent, at some point the Fed will lift rates again. For this reason, and because the market is currently priced for 20 bps of rate cuts over the next 12 months, we recommend that investors maintain below-benchmark portfolio duration. Investors should avoid Aaa-, Aa- and A-rated credits, but overweight the remaining corporate credit tiers. But how will the Fed decide when to take away the punch bowl? In a recent report we made the case that the two most important factors to monitor will be (i) inflation expectations and (ii) financial conditions.4 Last week’s FOMC minutes only strengthened our conviction in that view. The Fed On Inflation Expectations The March FOMC minutes showed that participants are concerned that inflation expectations have become un-anchored to the downside. In the Fed’s thinking, it must ensure that policy is accommodative enough to re-anchor inflation expectations. Otherwise, a Japanese-style scenario of permanent deflation could unfold. From the minutes:     Several participants observed that limited inflationary pressures during a period of historically low unemployment could be a sign that low inflation expectations were exerting downward pressure on inflation relative to the Committee’s 2 percent inflation target; Consistent with these observations, several participants noted that various indicators of inflation expectations had remained at the lower end of their historical range… In light of these considerations, some participants noted that the appropriate response of the federal funds rate to signs of labor market tightening could be modest provided that signs of inflation pressures continued to be limited. These concerns about low inflation expectations are not unfounded. Long-maturity TIPS breakeven inflation rates are well below the 2.3% - 2.5% range that has historically been consistent with “well anchored” expectations (Chart 3). The University of Michigan Survey of household inflation expectations is also well below pre-crisis levels (Chart 3, bottom panel). We expect monthly core CPI will print above 1.8% more often than not going forward. Our sense is that expectations are depressed because many years of low inflation have convinced markets that the Fed cannot sustainably hit its 2% target. In fact, our Adaptive Expectations Model – a model driven purely by measures of actual inflation – does a good job explaining movements in the 10-year TIPS breakeven inflation rate (Chart 4).5 At present, our model shows that the 10-year breakeven is close to fair value. Although we expect the fair value reading from our model to creep slowly higher over time. Chart 3First Battleground: Inflation Expectations Chart 4Adaptive Expectations Model The most important independent variable in our model is trailing 10-year core CPI inflation, which is currently running at an annualized 1.8% clip. This means that as long as monthly core CPI prints above 1.8% (annualized), it will send our model’s fair value reading higher over time. While core CPI has printed below that threshold in each of the past two months, we expect it will more often than not exceed it going forward. Notice that while year-over-year core CPI has rolled over, trimmed mean CPI has increased and median CPI just made a new cycle high (Chart 5). Meanwhile, small businesses continue to report an elevated rate of price increases and ISM prices paid surveys recently ticked up, after having fallen sharply earlier this year (Chart 6). Chart 5Encouraging Inflation Readings... Chart 6...Alongside Continued Price Pressures The Fed On Financial Conditions The Fed didn’t have much to say about financial conditions at the March 2019 meeting. In fact, looking through the minutes we could only locate the following relevant passage: A few participants observed that the appropriate path for policy, insofar as it implied lower interest rates for longer periods of time, could lead to greater financial stability risks. The lack of references to financial conditions shouldn’t be too surprising. Financial conditions aren’t nearly as accommodative as they were last autumn, and hence are currently much less of a policy concern (Chart 7): Chart 7Second Battleground: Financial Conditions The financial conditions component of our Fed Monitor is at 0.5. It was more than one standard deviation easier than average only a few months ago (Chart 7, top panel). The average junk index spread is still 46 bps above its 2018 low (Chart 7, panel 2). The GZ Excess Corporate Bond Risk Premium, an estimate of the excess spread in corporate bonds after accounting for expected default risk, still hasn’t recovered after widening sharply near the end of last year (Chart 7, panel 3).6 At 16.8, the S&P 500 Forward P/E ratio is almost back to its October level of 17 (Chart 7, bottom panel). Now consider that last year, when financial conditions were much more accommodative, the Fed was much more concerned. Fed Governor Lael Brainard and Chairman Jerome Powell both warned that signs of economic overheating could show up in financial markets before they show up in price inflation. Also, the minutes from the September 2018 FOMC meeting reveal that participants were willing to use the risk of “financial imbalances” as justification for tighter policy. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances.7 Bottom Line: The Fed is in no rush to tighten, and will remain on hold until inflation expectations or financial conditions give them a reason to resume hikes. Investors should take advantage by overweighting spread product while keeping portfolio duration low. Extend Maturity In Municipal Bonds Chart 8Municipal / Treasury Yield Ratios We continue to recommend that investors hold an overweight allocation to tax-exempt municipal bonds. Not only does the sector tend to outperform during the mid-to-late innings of the cycle,8 but value also remains attractive, with one key caveat: The best value in the municipal bond space is found at the long-end of the Aaa curve. The Value In Aaa Munis Chart 8 shows yield ratios for different maturities of Aaa-rated municipal debt relative to Treasuries. Notice that the 2-year and 5-year yield ratios, at 65% and 70% respectively, are close to one standard deviation below average pre-crisis levels. In fact, the all-time low for the 2-year Muni / Treasury yield ratio is 61%, only 4% below the current level. The all-time low for the 5-year yield ratio is 66%, also only 4% below the current level. The 10-year yield ratio looks almost as expensive as the 2-year and 5-year. At 76%, it is also close to one standard deviation below its average pre-crisis level. It is also only 6% above its all-time low. The real value in Aaa municipal bonds is found at the very long-end of the curve, in the 20-year and 30-year maturities where yield ratios, at 92% and 94% respectively, remain well above average pre-crisis levels (Chart 8, bottom two panels). While yield ratios out to the 10-year maturity point likely don’t have much room to compress, they could still look enticing depending on an investor’s tax situation. For example, a 76% 10-year Muni / Treasury yield ratio means that an investor facing an effective tax rate above 24% would still earn a positive after-tax yield pick-up in the municipal bond relative to the 10-year Treasury. The Value In Lower-Rated Munis Table 1Municipal Revenue Bonds / U.S. Credit Index Yield Ratios When we move outside the Aaa-rated municipal bond space we find that relative value starts to evaporate. Table 1 shows yield ratios between different municipal revenue bonds and the U.S. Credit index. We did our best to match the duration and credit rating of the different muni sectors as closely as possible. The table shows that the highest available Muni / Credit yield ratio is for 20-year A-rated munis, and even that yield ratio is only 73%. This means that an investor would need an effective tax rate above 27% to earn a positive after-tax yield pick-up relative to the U.S. Credit index. In other words, investors can add a fair amount of value by swapping Aaa-rated munis into their portfolios in place of Treasuries, especially at the long-end of the curve. There is much less incremental value to be gained from replacing corporate credit with lower-rated municipal debt. The Yield Ratio Curve Chart 9A Supportive Environment For Munis Our research shows that the yield ratio advantage at the long-end of the Aaa-rated muni curve tends to be greatest when the fundamental credit back-drop is supportive and municipal ratings upgrades are far outpacing downgrades (Chart 9). Conversely, when downgrades increase, yield ratios usually widen at the short-end of the curve relative to the long-end. At present, the muni ratings back-drop looks fairly supportive. While state & local government interest coverage dipped in Q4 (Chart 9, panel 2), it remains positive and should rebound as tax receipts move back to levels that are more consistent with the trend in nominal income growth (Chart 9, bottom panel). Periods of negative interest coverage tend to precede downgrade spikes. Under normal circumstances, a positive ratings outlook would suggest that yield ratios should fall more at the short-end of the curve than at the long-end, but there is very little chance that short-maturity yield ratios can compress further from current levels. Instead, it makes sense for investors to camp out at the long-end of the Aaa muni curve. Not only is the yield pick-up greater, but long-maturity yield ratios should better weather the storm when the cycle eventually turns. Bottom Line: The best value in municipal bonds is found at the long-end of the Aaa-rated municipal bond curve. Lower-rated and shorter maturity munis are much less appealing. Investors should focus their municipal bond exposure on Aaa-rated debt with 20-year and 30-year maturities. Fed Balance Sheet Normalization Almost Complete The Fed also presented a much more detailed plan for balance sheet normalization at the March FOMC meeting. To summarize the details: The Fed will continue to allow assets to passively run off its balance sheet until the end of September. Beginning in May, the Fed will reduce the monthly cap on Treasury redemptions from $30 billion to $15 billion. This means that if $16 billion of the Fed’s Treasury holdings mature in May, $15 billion will be allowed to run off and $1 billion will be reinvested. The current monthly cap of $20 billion for MBS remains unchanged. After September, the Fed will keep its overall assets constant but will continue to allow its MBS holdings to run down. It will reinvest the proceeds from MBS run-off into Treasuries. After September, even though the Fed will keep the asset side of its balance sheet constant, the supply of bank reserves will continue to shrink because the Fed’s other non-reserve liabilities – mostly currency in circulation – will continue to grow. Eventually, reserves will shrink to a level that the Fed deems optimal for the future implementation of monetary policy. It will then start to increase its asset holdings by purchasing Treasury securities. To implement this policy the Fed will likely announce a “minimum operating level” of desired reserve supply and then buy enough Treasuries to ensure that reserves stay above that level. The Fed has not announced which maturities it will target when it re-starts Treasury purchases. In our view, there are only two remaining questions when it comes to the Fed’s balance sheet policy. What Treasury maturities will it purchase going forward? And, when will it start buying Treasuries again? The Treasury’s cash holdings will continue to decline until the fall, putting upward pressure on the supply of bank reserves. On the first question, we will have to wait for an official announcement. Though in our view the Fed will choose a policy that reduces the risk that it will be perceived to be easing or tightening monetary policy through its purchases. This could be achieved by either concentrating its purchases in T-bills, or by targeting maturities in proportion to the Treasury department’s issuance schedule. The second question comes down to estimating the minimum reserve supply that will ensure banks are fully satiated, so that they don’t start competing for scarce reserve balances, driving up overnight rates in the process. While that equilibrium reserve number is unknown, the New York Fed’s most recent Survey of Primary Dealers shows that the 25th and 75th percentile of dealer estimates range from $1.1 trillion to $1.3 trillion. With those figures in mind, we can turn to the simplified Fed balance sheet shown in Table 2. The current balance sheet is shown along with what the balance sheet will look like when run off stops at the end of September. Table 2Simplified Fed Balance Sheet Projections To forecast the Fed’s balance sheet we assume that MBS runs off at a pace of $15 billion per month and that currency-in-circulation grows at an annual rate of 5%. We also estimate a range of possible values for the Treasury department’s General Account. This is the account where the Treasury keeps its cash holdings, which currently total $246 billion. Because the Treasury is currently engaged in extraordinary measures to prevent the U.S. from breaching the debt ceiling, this cash balance will almost certainly decline between now and when the debt ceiling is raised in the fall. After the debt ceiling is raised, the Treasury will probably start to re-build its cash balance. All else equal, a decline in the Treasury’s cash holdings puts upward pressure on the supply of bank reserves, while an increase in the Treasury’s cash holdings causes the supply of bank reserves to fall. According to Table 2, the supply of bank reserves will be between $1.42 trillion and $1.66 trillion by the end of September, still above most estimates of its equilibrium level. The table also shows that reserves will then shrink to between $1.35 trillion and $1.60 trillion by June 2020 and to between $1.31 trillion and $1.55 trillion by the end of 2020. Based on those figures and the dealer estimates, the Fed can probably keep its asset holdings constant through the end of 2020 without losing control of the policy rate or causing a disruption in money markets. However, we expect the Fed will err on the side of caution and start purchasing Treasuries again much earlier, possibly in the first half of 2020. The reason for the Fed to act quickly is that it faces asymmetric risks. The Fed risks losing control of the policy rate if it allows reserves to fall too far, but there is no real downside to keeping the balance sheet “too large”. In any event, the Fed has already demonstrated that it has the tools to conduct monetary policy with a large balance sheet. Bottom Line: The Fed has now announced almost all the details of its balance sheet normalization policy. The Fed’s asset holdings will stop falling at the end of September, and we project that it will start buying securities again in 2020. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20190320.pdf 2 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 3 We moved to overweight corporate bonds (both investment grade and high-yield) in in the U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com. The rationale for our spread targets is found in U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19 , 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 5 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 6 The Gilchrist and Zakrajsek (GZ) Excess Bond Premium is a measure of the excess spread available in a sample of nonfinancial corporate bonds after removing a bottom-up estimate of expected default losses for each security. Default losses are estimated based on the Merton Default model using each firm’s market value of equity and face value of debt. https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/files/…; 7  https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180926.pdf 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The first quarter is in the books, … : Risk may have been out in the fourth quarter, but it is squarely back in fashion so far this year, with equities and high yield posting gaudy first-quarter returns. … and events have compelled us to modify our high-conviction Fed call, … : There may yet be another four or more rate hikes, but they’re not going to occur this year. … but we’re still confident in our asset-allocation recommendations, … : The Fed may no longer be a menacing presence, but that doesn’t mean Treasuries and longer-maturity bonds are going to have it easy from here. … which should benefit from a more accommodative monetary policy outlook: Conditions remain favorable for equities and spread product, and unfavorable for Treasuries, even if the underlying drivers have shifted. Feature Table 1Whipsaw Newton’s Third Law holds that for every action there is an equal and opposite reaction. Markets have been busy supporting the theorem, as the fourth quarter’s sharp selloff has been nearly erased by the potent first-quarter rally (Table 1). Risk assets have been on a rollercoaster ride, though our economic outlook has been more or less unchanged. We chalked up the fourth quarter’s selloff to fears that the Fed was threatening the expansion. Conversely, the first quarter’s snapback likely owed quite a bit to the Fed’s pivot. By shifting its emphasis from trying to prevent inflation from getting away on the upside to trying to keep inflation expectations from falling too far, the Fed has gone from removing the punch bowl to promising to keep it full. In financial markets, risk assets should be the biggest relative beneficiaries. The Fed’s turn thwarted our more-hikes-than-expected call, at least in the near term. That surprise has been compounded by the administration’s seeming intent to pack the board of governors with nominees chosen solely on the basis of their uber-dovishness, and has inspired us to reflect on our calls. We like to share our reflections, as well as the internal BCA discussions and the client questions that shed light on our views. This week’s report examines some of the most important issues on our minds, and the minds of our colleagues and clients. Q: What does the Fed do from here? The quarterly summary of economic projections compiles FOMC meeting participants’ expectations for the likely path of key economic indicators (real GDP growth, unemployment and inflation) and monetary policy. The latest release revealed that Fed governors and regional presidents sharply dialed back their rate hike expectations between the December meeting and the March meeting (Chart 1). The median participant lopped 50 basis points (“bps”) off of his/her year-end 2019 and terminal fed funds rate projections, calling for no hikes in 2019 and just one more for the current cycle, in 2020. The rationale is a bit of a mystery, as the median participant’s estimates of GDP and inflation only came down modestly, and his/her unemployment rate estimates only rose modestly. It made sense for the Fed to turn away from the gradual pace of hikes it pursued in 2017 and 2018 in response to the sharp tightening in financial conditions brought on by the fourth-quarter selloff. The ensuing rallies in equities and high-yield bonds have undone much of that tightening, however. From a data perspective, it seems the Fed is mostly holding off to see how the outlook for the rest of the world evolves. The minutes of the March meeting, released last week, suggested that there may be more nuance to the Fed’s embrace of patience than markets initially perceived. The money markets had been calling for a 25-bps cut in the fed funds rate, to 2.25%, by the end of 2020; following the March meeting, they swiftly moved to price in a high likelihood of a second cut, to 2% (Chart 2). That outlook does not exactly accord with the committee’s more measured take: “Several participants observed that the [‘patient’] characterization … would need to be reviewed regularly[.] … A couple of participants noted that the ‘patient’ characterization should not be seen as limiting the Committee’s options[.] … Several participants noted that their views of the appropriate target range for the federal funds rate could shift in either direction[.] … Some participants indicated that if the economy evolved as they currently expected, … they would likely judge it appropriate to raise the target range … modestly later this year[.]” Chart 2... To Keeping It Full We continue to believe that the Phillips Curve is alive and well inside the Fed’s policy framework. The inverse relationship between inflation and unemployment is embedded in its macroeconomic models, and will compel the Fed to tighten policy in response to an unemployment rate that is nosing around 50-year lows (Chart 3). With the committee seemingly willing to let inflation get a bit of a head start before it tightens policy, it may well have to hike faster, and establish a higher terminal rate, than it otherwise would have if it had continued to follow a steady course. We believe the tightening cycle has been postponed rather than truncated, contrary to the money market’s view. Chart 3Sixties Flashback Bottom Line: The Fed is not going to take the fed funds rate to 3.25 - 3.5% by year end, as we expected late last year. We still believe the terminal rate is in that neighborhood, however, and the longer the Fed cools its heels, the greater the potential that it could exceed our estimate. Q: What is the outlook for the rest of the world? The March minutes revealed that conditions in the rest of the world continue to influence the Fed’s policy decisions. The slowdown in China, the uncertain outcomes of ongoing trade talks and Britain’s separation from the EU shadow the outlook in emerging economies and the major non-U.S. developed economies. The outlook for China, other emerging markets, and Europe have been a spirited subject of discussion within BCA. With a majority of the managing editors perceiving the signs of some green shoots, we upgraded Chinese equities to overweight from equal weight, and European and EM equities to equal weight from underweight, at our monthly View Meeting last week. An end to China’s deleveraging campaign may be all the rest of the world needs to show a little more life. Chart 4As China Goes China is a critical influence on our global view. We expect that policymakers have already begun de-emphasizing their deleveraging campaign, as suggested by March’s credit data, released Friday, and will encourage lenders to lend. No one at BCA expects a stimulus campaign on the order of the massive 2008 and 2016 efforts, but the general view is that policymakers can take steps to end the deceleration in China’s growth, since it was rooted in their deleveraging drive. The deceleration weighed on trade and manufacturing activity around the world (Chart 4), and may have been the catalyst for the global mini-slowdown. The rest of the world should benefit from the easing in financial conditions driven by the global equity rally. The decline in bond yields has also helped ease financial conditions, and the nearly unanimous dovishness of major-economy central banks may provide investors and consumers with additional comfort. The key issue for the U.S. economy, and U.S.-oriented investors, is whether or not the other major economies will slow enough to cool off the U.S. at a time when its fiscal impulse is slowing. We have a sense that China and Europe are beginning to turn, and we do not expect spillovers to drag on U.S. growth, but continued rallies in U.S. risk assets probably require some sort of revival beyond its shores. Q: How do corporate profits look? Is the consensus overly optimistic? The corporate profit outlook is getting less ambitious by the day. Over the last three months, consensus expectations for first quarter S&P 500 share-weighted earnings have fallen by 6.5%, as analysts downwardly revised their year-over-year growth projections from +3.5% to -2.2%. Management teams seek to under-promise and over-deliver, and do their best to guide analyst expectations to a level their companies can exceed. Since 1994, according to Thomson Reuters, about two-thirds of companies have reported earnings that beat estimates. On average over that stretch, companies have beaten estimates by a margin of 3.2%. We are therefore inclined to take the projected earnings contraction with a grain of salt. Corporations seem to have lowered the bar to a level they should be able to clear without too much trouble. Chart 5Wages Aren't Yet Pressuring Margins ... We are further inclined to question the projected 2.2% contraction in earnings, given that revenues are projected to grow by 5% in the quarter. The disparity implies margin contraction of close to 7%. Compensation is the largest component of corporate expenses, with the remainder roughly split between interest expense and other input costs. The other meaningful input is the dollar, which should most often exhibit an inverse relationship with margins. Real unit labor costs is the compensation series that most directly impacts profit margins, and it has been contracting on a year-over-year basis, augmenting margins (Chart 5). It will continue to do so as long as nominal wage growth lags inflation and productivity gains. BBB-rated corporate yields were materially higher in the first quarter than they were a year ago, and may have taken a modest bite out of margins, but they’re now back to where they were then and cannot explain the projected 7-ppt margin haircut by themselves (Chart 6). Producer prices grew just 2.2% on a year-over-year basis, slightly ahead of consumer prices (Chart 7), suggesting that margins only slightly narrowed from the disparity between input costs and selling costs. Chart 6... And Interest Rates Aren't Anymore Chart 7Input Costs Are Manageable The broad trade-weighted dollar gained 6% from 1Q18 to 1Q19. Assuming corporations lower prices to defend market share against foreign competitors, profit margins should fall when the dollar rises. Dollar appreciation likely exerted some incremental pressure on margins, but the internal model we’ve previously referenced pegs the EPS impact of a 10% rise in the dollar at 2.5%, far too small for a 6% rise in the dollar to drive a 7-ppt fall in margins. If the revenue estimates are accurate, it seems to us that management must be sandbagging its earnings guidance to some degree. The 10-year Treasury yield will have a harder time falling further now that the Fed is already awfully dovish. Q: Are you having any second thoughts about your duration recommendation? Our below-benchmark duration call was largely founded on our expectation that the Fed was going to surprise complacent markets by hiking more than they expected. It instead surprised dovishly, and the OIS curve responded by pricing in an additional rate cut by the end of next year. The 10-year Treasury yield melted, in accordance with our U.S. Bond Strategy service’s golden rule1 (Chart 8). Chart 8The Golden Rule The surest way to mess up a Fed call is to allow what one thinks the Fed should do to intrude on one’s assessment of what the Fed will do. We did not fall into that trap: our view that the Phillips Curve exerts considerable influence over the Fed and other central banks is founded in the observation that virtually every mainstream macroeconomic model incorporates an inverse relationship between inflation and unemployment. As noted above, we see the Fed’s hiking campaign as extended rather than ended. We believe pausing the hiking campaign will extend the expansion and allow the economy to build up more momentum. More momentum would merit higher real rates, and we also expect it would promote inflation pressures given that the output gap is already closed. We were admittedly on the wrong side as the 10-year Treasury yield fell from 3.25% to 2.4%, but still lower yields would be incompatible with our constructive view of the U.S. economy. With much of the drag on Treasury yields seeming to have come from overseas, it’s also important to note that lower major-economy yields would be incompatible with our house view that the global economy is on the cusp of rebounding (Chart 9). Chart 9Yields Rise When Green Shoots Appear Bottom Line: We missed the slide in the 10-year Treasury yield because we failed to foresee the Fed’s pivot, and because we may have focused too much on U.S., rather than global, conditions. We do not see yields falling much further, however, now that the Fed’s capacity for dovish surprises is spent, and green shoots are starting to appear in China and Europe. Q: How was the Final Four? Fantastic, and we recommend gathering some old college friends and making the trip to cheer on your alma mater should it qualify. Bring your kids if they’re old enough. If your school wins it all, you’ll share lifelong memories of the sort the Virginia alumni who attended the games will cherish. We’ll always have Minneapolis. Go ‘Hoos!   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      Treasuries beat cash when the Fed hikes less than the money market expects, and lag cash when it hikes more than expected. Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy   If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 10Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of our country Monitors are now forecasting monetary policy on hold, apart from Australia and New Zealand where looser policy is warranted (Chart of the Week). However, with early leading indicators now flagging a trough in global growth, and with labor markets mostly tight, the Monitors may not signal a need for incremental easing since inflationary pressures have not decelerated much. Given how far global bond yields have fallen in response to the weaker growth backdrop over the past year, any sign of the Monitors finding a floor would herald a turnaround in overbought global government bond markets – most notably in the U.S. and core Europe, where a below-benchmark strategic duration stance is most appropriate. Feature Chart of the WeekA Synchronized Pullback In The BCA Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Bond Yields Have Fully Adjusted To Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocations for global government bonds reflect the trends seen in the Central Bank Monitors, even as they have all shifted lower. We are favoring countries where the Monitors are falling (Australia, the U.K., Japan, New Zealand and Canada) relative to regions where the Monitors appear to be stabilizing (the U.S., core Europe). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against money market yields curves (the spread between 1-year government bond yields and central bank policy rates, to measure expected changes in interest rates). Fed Monitor: No Rate Cuts Needed Our Fed Monitor has drifted lower over the past several months and now sits just above the zero line (Chart 3A). That indicates no pressure to hike interest rates, which is consistent with the Fed’s recent dovish turn. Yet the Monitor is also not yet in the “easier money required” zone that would suggest a need for the Fed to lower the funds rate - even though that is an outcome now discounted in the U.S. yield curve. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Markets have gotten ahead of themselves with the expectation of Fed rate cuts. Yes, the U.S. has finally seen some negative impact from slower global growth and the late-2018 tightening of U.S. financial conditions. However, those factors are now starting to become less negative for growth – most notably the across-the-board rally in equity and credit markets in Q1 that has eased financial conditions. There is little danger of a shift to a sustained period of below-trend growth (i.e. less than 2%) in 2019 that would free up spare capacity, and ease inflation pressures, in the U.S. economy (Chart 3B).   Chart 3AU.S. Treasury Rally Looks Overdone Chart 3BA Big Pullback In U.S. Inflation Is Unlikely Among the three sub-components of the Fed Monitor (growth, inflation and financial conditions), all are close to the zero lines (Chart 3C), suggesting that the current neutral signal from the Monitor is broad-based. The rally in the U.S. Treasury market now looks stretched, however, with the 10-year yield now lower than levels of a year ago – an outcome that, in that past, has usually coincided with the Fed Monitor falling well below zero (Chart 3D). A below-benchmark duration stance in the U.S. is appropriate, as the risk/reward profile favors higher Treasury yields from current depressed levels. Chart 3CFed Monitor Components All Near Zero, Validating Current Fed Pause Chart 3DU.S. Treasury Rally Looks Overdone BoE Monitor: The Window For A Rate Hike Has Closed Our Bank of England (BoE) Monitor, which had been in the “tighter money required” zone between 2016-18, has fallen back to the zero line (Chart 4A). The obvious culprit is the ongoing Brexit uncertainty, which has damaged confidence among both businesses and consumers. Overall economic growth has held in better than expected given the Brexit noise – for example, the manufacturing PMI now sits at 55.1, comfortably above the boom/bust 50 threshold. Yet leading economic indicators continue to deteriorate and growth is likely to remain under downward pressure in the coming months. Despite estimates showing a lack of spare capacity in the U.K. economy (a closed output gap, an unemployment rate well below NAIRU), both headline and core inflation have fallen back to the BoE’s 2% target (Chart 4B). The central bank has changed its policy bias as a result, with even the more hawkish members of the Monetary Policy Committee signaling that there is no longer any pressing need for rate hikes.   Chart 4AU.K.: BoE Monitor Chart 4BU.K. Inflation Back To BoE Target When looking at the split between the growth and inflation components of our BoE Monitor, it is clear that the former has triggered the large fall in the Monitor (Chart 4C). Yet even the inflation component has fallen below the zero line. With no pressure from any corner to alter monetary policy, the BoE can continue to sit on its hands and wait for some clarity to develop on the Brexit front. Chart 4CHit To U.K. Economy From Brexit Uncertainty Keeping BoE On Hold We continue to recommend overweighting U.K. Gilts within global government bond portfolios, given the weakening trend in U.K. leading economic indicators and persistent Brexit uncertainty (Chart 4D). Chart 4DA Deeper U.K. Growth Slowdown Needed To Drive Down Gilt Yields ECB Monitor: Bund Yields Have Fallen Too Far Our European Central Bank (ECB) Monitor is slightly below the zero line, signaling no real need for any change to euro area monetary policy (Chart 5A). The sharp slowing of economic growth last year, driven primarily by plunging exports, is the main reason why the Monitor has stayed subdued. Despite the weaker growth momentum, however, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area Inflation More Stable At Full Employment   Nonetheless, the ECB has already back-pedaled on policy normalization announced last December. The central bank announced a new program of cheap funding for euro area banks (TLTRO3) to begin this September, replacing the expiring loans from the previous funding program. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor. There are some tentative signs that euro area growth may be stabilizing, such as increases in the expectations component of the ZEW and IFO surveys. If this is the beginning of a true cyclical turnaround, then the downward pressure on our ECB Monitor from a weak economy will soon reverse (Chart 5C). Chart 5COffsetting Growth & Inflation Components In The ECB Monitor The ECB is now signaling that it will keep policy rates unchanged until the end of the year, on top of the new TLTRO. In addition, faster global growth in the latter half of 2019 will provide a boost to the euro area economy via the export channel. The backdrop is turning less bullish for core European bond markets, where yields have fallen much further than justified by our ECB Monitor (Chart 5D). We recommend only a neutral allocation to core European government bonds, but our next move is likely a downgrade. Chart 5DBund Rally Looks Stretched Versus ECB Monitor BoJ Monitor: No Inflation, No Change In Policy Our Bank of Japan (BoJ) Monitor has drifted back to the zero line after a brief cyclical stay in the “tighter money required” zone in 2017/18 (Chart 6A). Such is life in Japan, where even an unemployment rate of 2.3% – the lowest in decades – cannot generate inflation outcomes anywhere close to the BoJ’s 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation The slowing of global trade activity and weakness in Chinese economic growth has hit the export-sensitive Japanese economy hard. Industrial production is now contracting, export volumes fell –6.8% year-over-year in January, and the widely-followed Tankan survey showed the biggest quarterly drop in business confidence among manufacturers in Q1/2019 since 2011. Household confidence has also taken a hit and retail sales growth has stagnated. Against such a weak economic backdrop, the soft growth component of our BoJ Monitor is fully offsetting the relative strength of the inflation component (Chart 6C). The latter is mostly related to the tightness of Japan’s labor market, which has pushed nominal wage inflation to 3.0% - the fastest pace since 1990. Core inflation at 0.4% has not followed suit, however. Chart 6CStill Not Enough Growth To Justify Any Reduction in BoJ Accommodation We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings – especially compared to the rest of the developed markets – until there is much higher realized core inflation in Japan. There is no chance of the BoJ moving any part of the Japanese yield curve it effectively controls (all interest rates with maturity of 10 years of less) until both growth and inflation move durably higher (Chart 6D). Chart 6DNo Pressure On JGB Yields To Rise BoC Monitor: Neutral Across The Board Our Bank of Canada (BoC) Monitor has fallen sharply since mid-2018 and now sits right at the zero line, suggesting no pressure to change monetary policy (Chart 7A). The main cause is weakness in the Canadian economy, which has responded negatively to the combination of previous BoC rate hikes, diminished business confidence and slower global growth. The central bank was surprised by how rapidly the Canadian economy lost momentum at the end of last year, when real GDP expanded an anemic 0.4% annualized pace in Q4/2018. That prompted the BoC to signal a halt to the rate hikes, even with core inflation measures hovering close to the midpoint of the BoC’s 1-3% target band (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BIs Economic Slack Underestimated In Canada? Canadian money markets now discount -20bps of rate cuts over the next year. In the past, market pricing of BoC rate expectations has tended to be more correlated to the inflation component of our BoC Monitor (Chart 7C). The latest downturn in the Monitor, however, has been driven by declines in both the growth and inflation components. The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7CBoC Monitor Components Both Consistent With No Change In Interest Rates We closed our long-standing underweight recommended allocation for Canadian government bonds on March 19.1 We are now at neutral weight, although we may shift to an overweight stance if the coming rebound in global growth that we expect does not carry over into the Canadian economy and trigger some stabilization in our BoC Monitor (Chart 7D). The BoC’s dovish turn is validated by broad-based weakness in the Canadian data. Chart 7DCanadian Yields Will Not Rise Again Without A Rebound In Growth RBA Monitor: More Pressure To Cut Rates The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). A slumping economy has been weighed down by sluggish consumption, weak exports and falling house prices in the major cities. Combined with inflation stubbornly below the 2-3% RBA target band, this has driven Australian bond yields to new lows. -41bps of RBA rate cuts over the next year are now discounted in the Australian OIS curve. Delivering on those rate cut expectations, however, will likely require some weakening of the labor market (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BAustralia: RBA Monitor As depicted in Chart 8C, both the growth and inflation components of our RBA Monitor have fallen below the zero line. Over the past quarter-century, when both components of the RBA Monitor were as far below zero as they are now, shorter-dated bond yields have ended up falling below the Cash Rate as markets move to price in an easing cycle. That 1-year/Cash Rate spread has not yet gone negative, suggesting there is more room for the entire Australian government yield curve to be dragged lower by the front-end if the economy does not soon improve. Chart 8CSoft Inflation Is Why Our RBA Monitor Is Calling For Cuts The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive. The positive correlation between the RBA Monitor and changes in the 10-year Australian government bond yield suggests that downward pressure on yields will persist until economic growth or inflation begins to revive (Chart 8D). With Australia’s leading economic indicator still decelerating, and with any boost to exports not likely until later this year, we continue to recommend an overweight stance on Australian government bonds. Chart 8DStay Long Australian Bonds RBNZ Monitor: Setting Up For A Rate Cut Our Reserve Bank of New Zealand (RBNZ) monitor has been below the zero line since September 2018, indicating that easier monetary policy is required. (Chart 9A). The central bank made a significant dovish shift in its forward guidance at the March meeting, noting that the balance of risks for the New Zealand (NZ) economy was now tilted to the downside and the next move is more likely to be a rate cut. That dovish turn is consistent with the underwhelming performance of NZ inflation (Chart 9B). The RBNZ does not expect inflation to hit 2% until the end of 2020, even with the unemployment rate at a ten-year low of 4.3% and wages growing at a 2.9% annual rate. Chart 9ANew Zealand: RBNZ Monitor Chart 9BNZ Inflation Has Struggled To Breach 2% Over the past two decades, market pricing of RBNZ rate moves has been more correlated to the growth component of our RBNZ Monitor. In the years since the Global Financial Crisis, however, the growth and inflation components have been highly correlated to each other and to expectations for interest rates (Chart 9C). With markets now discounting -45bps of rate cuts over the next year, the NZ yield curve appears appropriately priced relative to our RBNZ Monitor. Chart 9CBoth Inflation & Growth Components Of The RBNZ Monitor Signaling Rate Cuts We have maintained a bullish recommendation on NZ government bonds versus both U.S. Treasuries and German Bunds since mid-2017, and we see no reason to close this highly profitable position, even if the RBNZ fails to fully deliver on discounted rate cuts. Both Treasuries and Bunds look overvalued amid signs of U.S. and European growth stabilizing, while the deterioration in our RBNZ Monitor suggests NZ yields have far less upside (Chart 9D). Chart 9DStay Long New Zealand Government Bonds Riksbank Monitor: Rate Hikes Delayed, Rate Cuts Unlikely Our Riksbank Monitor is currently slightly below zero and market is now priced for -17bps of rate cuts over next year (Chart 10A). The market has judged that the recent bout of weaker Swedish economic data has effectively derailed the Riksbank’s plans to hike rates in the second half of 2019. However, given the dearth of spare capacity in the Swedish economy (Chart 10B), and with the policy rate still negative, rate cuts are unlikely to be delivered. At best, the central bank can delay rate hikes if growth continues to disappoint, which also supports easier monetary conditions via a weaker exchange rate (the krona is down -4.7% year-to-date). Chart 10ASweden: Riksbank Monitor Chart 10BSweden Inflation Cooling Off A Bit The Riksbank stated in its February Monetary Policy Report that low Swedish productivity growth is leading to cost pressures through higher unit labor costs. It also forecasts that faster wage growth over the next year will help keep inflation near the 2% Riksbank target. The implication is that it will take much weaker growth, and higher unemployment, before the central bank will completely abandon its quest to normalize Swedish interest rates. The relationship between the growth/inflation components of our Riksbank Monitor and the market’s interest rate expectations has been weak since the central bank cut rates below zero and introduced quantitative easing in late 2014 (Chart 10C). Prior to that, however, it was the growth component that was more correlated to short-term interest rate expectations. On that note, the rebound in global growth that we are expecting will help support the Swedish economy, which is highly geared to global economic activity, and put a floor under Swedish bond yields (Chart 10D). Chart 10CRiksbank Can Stay On Hold Chart 10DNo Pressure For Higher Sweden Bond Yields Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see Global Fixed Income Weekly Report “March Calmness,” published March 19, 2019. Available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Table 1Fed Won’t Be Able To Cut This Much Next Time   Chart 2Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound?   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Chart 27How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Special Report

Dear Client, Instead of our regular Weekly Report, this week we are sending you a Special Report written on February 20 by our Geopolitical Strategy service colleagues that discusses China’s recent stimulating efforts. We have only made a few minor revisions to account for the past month’s events. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist   Highlights So What? China’s January-February credit data suggest that stimulus is here. Why? China’s early-year credit and fiscal policies suggest that stimulus risks are to the upside. January-February credit was a blowout number and fiscal spending is up. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January-February improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January-February’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January-February, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January-February numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January-February’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. This year’s January-February numbers are very strong relative to previous years (Chart 3) and the context is more accommodative than the 2017 January-February credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing. Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. A new round of two-week shuttle diplomacy is beginning. Trump has extended the tariff ceasefire and the two sides reportedly have arrived at an agreement on currency and are drafting written agreements on other areas of dispute. China’s National People’s Congress has passed a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January-February credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France. The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However, BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices. Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism). We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Highlights The yield curve has inverted: The 10-year Treasury bond yield fell below the 3-month T-bill rate following the March FOMC meeting and has remained there since. We never say it’s different this time, but there is not yet sufficient evidence to change course: The yield curve is almost always early as a standalone signal, and the depressed term premium may make it less sensitive right now. Monetary policy still looks decidedly accommodative to us, … : Our estimate of the equilibrium fed funds rate says policy’s easy, and that it’ll stay that way until the Fed gets serious about hiking rates again. … so asset allocation should continue to favor risk assets: There are global forces restraining Treasury yields, but the fed funds rate cycle is only partway through a stretch that has been uniformly unfavorable for Treasuries. Feature Last week’s data were soft, as the U.S. economy continues to show signs of decelerating. The consumer confidence survey disappointed hopes for an extended bounce back from January’s shutdown-shadowed release, housing starts were uninspiring, and the Case-Shiller index revealed that home-price gains continue to sag. Beyond the U.S., the message from manufacturing PMIs is glum, although the services sector seems to be holding up just fine. Our traveling colleagues report that investors around the world have developed a decided aversion to European assets. We remind our clients that deceleration is nothing new. It’s been the story so far this year, as the incremental decline in fiscal thrust ensured it would be. The inversion of the yield curve is new, however, and it’s commanding attention from the financial media and from investors drawn to a leading indicator that consistently works. We like the yield curve, too, and it’s one of the three components of our recession indicator, but it’s only one. The other two components have yet to confirm its message, and the way things look now, it may well be awhile before they do. The Yield Curve Has Inverted, The Yield Curve Has Inverted The 3-month-to-10-year segment of the yield curve inverted after the March FOMC meeting, and it dipped a little further into negative territory last week as the 10-year Treasury yield continued to melt. An inverted curve is one of the three components of our simple recession indicator,1 and we believe it can send an important signal about the economy’s vigor and the state of monetary policy. By itself, however, an inverted curve is not a sufficient precondition for a recession. It has also been something less than a timely guide to asset allocation, inverting a year ahead of a recession, on average, and six months before the S&P 500 peaks (Table 1). The yield curve has been a reliable recession warning signal, but it tends to be too early to serve as a practical guide to money management and asset allocation. Table 1Inverted Yield Curves, 1968 - 2018   An inverted yield curve has called eight of the seven recessions that have occurred over the last 50 years, making it a dependable leading indicator (Chart 1). Year-over-year contraction in the Conference Board’s Leading Economic Index (LEI) has compiled the same enviable track record, calling all seven of the last half-century’s recessions with just one false positive (Chart 2). LEI tends to be timelier, however, sounding the alarm an average of five months after the curve inverts (Table 2). For our recession indicator, we also add a comparison of the fed funds rate to our estimate of the equilibrium fed funds rate, because recessions have only occurred when the fed funds rate has exceeded our estimate of the equilibrium rate (Chart 3). Chart 1The Yield Curve Has Been Reliable, Albeit Early Chart 2LEI Has Been Timelier Table 2LEI Contractions, 1968 - 2018   The cycle is extended, and the inverted curve has made us even more alert for trouble in the economy and financial markets, but we do not think trouble is imminent. The LEI is clearly decelerating, but it has yet to contract. We currently peg the equilibrium fed funds rate at about 3⅛%, and project that it will rise to 3⅜% by the end of the year. We can’t know the equilibrium rate with exact precision in real time, but our estimate has been a reliable guide to financial market performance, and the fact that the fed funds rate is four 25-basis-point hikes from crossing the line gives us some comfort that neither a recession nor a bear market is waiting just around the corner. Chart 3Recessions Only Occur When Policy Is Tight Bottom Line: We are not dismissing the inverted yield curve, but our other recession-indicator inputs are not confirming its warning. Given the Fed’s new guidance, we expect that the next recession will not arrive before mid-to-late 2020. It’s A Little Bit Anomalous This Time At its best, an inverted yield curve is a signal from the bond market that the Fed has tightened monetary policy too much, heralding future rate cuts and a sharp slowdown. Anything affecting yields at the long end, however, has the potential to skew the curve’s signal. If long yields were somehow inflated, the curve would be less prone to invert and the signal would be delayed. If long yields were restrained, the curve would be prone to invert sooner and the signal might come especially early. Rate hikes invert the curve once the bond market decides they’re unnecessary, or expects that they’re going to be reversed soon. We believe that the yield curve currently has a bias to invert even earlier than it otherwise would. The question of how much the Fed’s asset purchases have affected the term premium,2 if at all, is far from settled within either the Fed or BCA, and is beyond the scope of this report. Nonetheless, we do think that QE1, QE2, and QE3 must have made some contribution to the decline in the term premium on long-term bonds (Chart 4). The bottom line is that we think the curve was disposed to invert earlier this time around. Its signal is still worth incorporating into our analysis, but we will seek confirmation from our other recession indicators before revamping our asset-allocation recommendations in line with an approaching inflection point in the business cycle. Chart 4The Curve Inverts More Easily When The Term Premium Is Negative The Fed And The Yield Curve We subscribe to the idea that the Fed induces recessions by removing monetary accommodation in an attempt to keep the economy from overheating. It’s simply too difficult to achieve a soft landing with policy tools that influence activity indirectly and with long and variable lags, given that the dual-mandate metrics are themselves lagging indicators. Compared to the path by which the Fed influences the economy, the path by which it inverts the curve is simple and straightforward. It raises short rates, and the long end rises as well, as the bond market discounts higher inflation and/or stronger growth, until investors no longer believe that inflation or growth prospects merit tighter policy, and long rates fall behind short rates. We reviewed moves in 10-year yields and 3-month rates across the different phases of the fed funds rate cycle (Chart 5) to see how the process has unfolded empirically. As the mechanics of yield curve inversion imply – short rates rise, long rates rise less or fall – the curve bear flattens when the Fed hikes the fed funds rate, and bull steepens when it cuts it (Table 3). The outcome fits the intuition: if the Fed’s attempt to slow the economy with higher short rates is successful, real interest rates will decline, inflation pressure will ease and bond yields should fail to keep pace with bill rates, especially if investors associate tightening campaigns with recessions. Conversely, if the Fed successfully boosts the economy with lower short rates, bond yields should fall less than short rates as the real component of rates rises, and the curve should steepen. Table 3The Yield Curve And The Fed Funds Rate Cycle Depicting our stylized fed funds rate as a bell curve makes for an appealing picture, but it obscures the fact that the Fed often pauses for a while after hiking rates to their cyclical peak, or cutting them to their cyclical trough. Phase II doesn’t end until the beginning of the next rate-cutting campaign, and Phase IV doesn’t end until the beginning of the next series of rate hikes. A stricter representation of the fed funds rate cycle would have two phases of active hiking, followed by a state of limbo between the last hike and the first cut, then two phases of active cutting, followed by a lull during which the Fed waits for signs that it should remove accommodation. The expanded fed funds rate cycle is therefore composed of active hiking in Phase I and Phase II(a), pre-easing in Phase II(b), active easing in Phase III and Phase IV(a), and pre-hiking in Phase IV(b). Table 4 shows the average monthly changes in the yield curve and its components in the expanded fed funds rate cycle. There is quite a difference between Phase II(a), when the curve aggressively bear flattens, and Phase II(b), when the curve modestly bull flattens. Phase IV(a) features a sharp bull steepening, while the long end drifts higher in Phase IV(b) and short rates barely budge. Ultimately, the real action happens when the Fed is actively adjusting monetary policy, and the duration positioning implications are quite sensitive to the transitions into and out of the active phases. Table 4The Yield Curve And The Expanded Fed Funds Rate Cycle Bonds And The Fed Funds Rate Cycle An inverted yield curve has provided a reliable early-warning signal about recessions, but it can be too early to drive asset-allocation decisions for a manager judged on relative returns. The curve moves in Tables 3 and 4 offer more timely implications for duration positioning within fixed-income portfolios across the fed funds rate cycle. It comes as no surprise that Treasuries perform better when the Fed is cutting rates (Phases III and IV) than they do when the Fed is hiking them (Phases I and II). Their returns should be inversely correlated with the direction of rates, and longer-maturity instruments should exhibit greater sensitivity to changes in the fed funds rate (Table 5). Table 5Treasuries And The Fed Funds Rate Cycle Overweight duration within bond portfolios from when the Fed stops hiking rates until it stops cutting them; underweight duration when it’s actively hiking. Expanding the fed funds rate cycle to account for active hiking, active easing, and the pre-hiking/pre-cutting limbo periods makes the duration-positioning road map clearer. Treasuries lose ground in real terms when the Fed is actively hiking, with longer-maturity instruments bearing the brunt (Table 6). They deliver in a big way when the Fed is actively easing (Phase III and Phase IV(a)), with the Barclays Bloomberg Long Treasury Index posting double-digit annualized total returns. Longer Treasuries shoot out the lights once the Fed stops hiking (Phase II (b)), and they generate real total returns that compare favorably with bull-market equities when aggregating Phase II(b)’s pre-easing results with active-easing Phases III and IV(a). Table 6Treasuries And The Expanded Fed Funds Rate Cycle Our terminal and equilibrium fed funds rate estimates are admittedly far from the consensus. Markets are skeptical of the FOMC’s one-more-hike projection, much less our three, four, or more terminal-rate call. With “secular stagnation” searches ascendant on Google Trends (as of Friday morning, the partially complete March 24-30 period already had the most searches of any week over the last twelve months), our equilibrium estimate is also surely out of step with the herd. If the Fed is not done, however, history says it’s not yet time to overweight duration. If we’re right, Treasuries still have the full Phase II(a) ahead of them, and won’t be a buy until the Fed desists, sometime in 2020 or beyond. Investment Implications We have taken note of the inverted yield curve, but we will not overreact to it. While it has been a reliable recession indicator for the last half-century, it consistently sounds the alarm too early to merit immediate investment action. Neither the LEI nor our equilibrium fed funds rate model has yet corroborated its warning, and the bombed-out term premium may have biased it to inverting even sooner than it otherwise would. There’s no need for Paul Revere to ready his horse just yet. We did not anticipate that the 10-year Treasury yield would decline as much as it has. The extent of the Fed’s dovishness caught us off guard, and the 10-year Treasury is having a very hard time escaping the gravity of the decline in major-economy sovereign yields around the world. Our Global Fixed Income Strategy service (GFIS) points out that the global yield decline has become extended (Chart 6), and it contends that global bond prices incorporate too much pessimism about global economic momentum. The GFIS team also notes that there’s no guarantee stock prices will fall to align with bond yields – over the last couple years, stocks and bonds have recoupled following yield scares via bond, not equity, sell-offs (Chart 7). Chart 6Enough Is Enough Chart 7Equities Have Been Smarter Than Bonds The Last Few Years We therefore remain constructive on the economy and financial markets, and advise that balanced portfolios should still maintain exposure to riskier assets. Much of that view depends on Chinese authorities relaxing their deleveraging campaign, global trade tensions easing, and some hint of green shoots appearing in the rest of the world. If those elements of our base-case scenario fail to materialize, we will likely become more cautious. We are not happy that the vindication of our high-conviction view on the terminal fed funds rate has been indefinitely delayed, but the silver lining of the Fed’s dovish surprise is that the bull market in equities and other risk assets has been granted an open-ended extension.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?,” published August 13, 2018. Available at usis.bcaresearch.com. 2 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument.

Highlights Global equities and other risk assets will trade sideways with elevated volatility over the coming weeks before grinding higher for the remainder of the year, as global growth finally accelerates after a series of false starts.  We now see the Fed raising rates more slowly than we had previously envisioned, but ultimately having to scramble to hike rates in order to quell inflation. The fed funds rate will probably plateau at 4% in 2021, implying nine quarter-point hikes more than the market is currently discounting.   Over a 12-month horizon, investors should overweight global equities, underweight government bonds, and maintain a neutral allocation to cash. The dollar will peak in the second quarter and then weaken over the remainder of the year and into 2020, before starting to strengthen again late next year. Investors should prepare to temporarily upgrade EM and European stocks over the coming weeks, while increasing exposure to cyclical equity sectors. Industrial metals and oil will strengthen over the course of the year. Gold should be bought on any dip. Investors should begin to de-risk their portfolios in late-2020 in anticipation of a recession in 2021.   Feature Here We Go Again? After having become more defensive last June, we turned bullish on stocks following the December post-FOMC meeting plunge. As stocks continued to rebound, we tempered our optimism. In the beginning of March, we wrote that “having rallied since the start of the year, global stocks will likely enter a ‘dead zone’ over the next six-to-eight weeks as investors nervously await the proverbial green shoots to sprout.”1 Last Friday’s release of disappointing European PMI data poured some herbicide on the green shoots thesis. Germany’s manufacturing PMI hit a six-year low, with the new orders component registering the weakest reading since the Great Recession. This took the 10-year German bund yield into negative territory for the first time since 2016. The U.S. 10-year Treasury yield also fell to a 15-month low, causing the 3-month/10-year curve to invert. Historically, an inverted yield curve has been a reliable predictor of U.S. recessions (Chart 1). Chart 1Yield Curve Inversions, Recessions, And The Term Premium President Trump’s decision to appoint TV commentator Stephen Moore to the Fed’s Board of Governors did not help matters. Recommended by fellow supply-side “economist” Larry Kudlow, Moore is best known for dismissing concerns over the state of the housing market in 2007, his spot-on 2010 prediction that QE would cause hyperinflation, and his belief that the Trump tax cuts would lead to a smaller budget deficit. Global Growth Will Accelerate In The Second Half Of The Year Given all these worrisome developments, is it time to turn cyclically bearish on the economic outlook and risk assets again? We do not think so. While the next few weeks could be challenging for equities – a risk that our MacroQuant model is currently flagging – sentiment should improve as global growth finally accelerates after a series of false starts.  Indeed, some positive signs are already visible: The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has moved higher (Chart 2). It leads the global LEI. Service sector PMIs have also generally improved, suggesting that the weakness in global growth remains concentrated in trade and manufacturing. And even on the trade front, a few forward-looking indicators such as the Baltic Dry Index and the weekly Harpex shipping index, which measures global container shipping activity, have bounced off their lows. We would downplay the signal from the yield curve, as it currently is severely distorted by a negative term premium. If the 10-year Treasury term premium were back to where it was in 2004, the 3-month/10-year slope would be more than 200 bps steeper, and nobody would be talking about this issue. In fact, given today’s term premium, the curve would have almost certainly inverted in 1995. Anyone who got out of stocks back then would have missed out on one of the greatest bull markets in history. It should also go without saying that some of the decline in the U.S. 10-year yield reflects a positive development: The Fed has turned more dovish! If one looks at the 10-year/30-year portion of the yield curve, it has actually steepened. This is a sign that the market is seeing the Fed’s actions as being reflationary in nature. There is no clear causal mechanism by which an inverted yield curve slows economic activity, apart from it potentially becoming a self-fulfilling prophecy where the yield-curve inversion scares investors, thereby leading to a tightening in financial conditions (Chart 3). Such “doom loops” are conceptually possible, but as we discussed earlier this year, they are unlikely to occur in the current environment.2 At any rate, financial conditions have eased since the start of the year. This should boost growth in the coming months.   Chart 2Global Growth May Be ##br##Starting To Stabilize Chart 3Easier Financial Conditions Since The Start Of The Year Bode Well For Global Growth Chinese Credit Growth Set To Rise Global growth has been weighed down by a slowing Chinese economy. Last year’s deleveraging campaign led to a significant deceleration in investment spending, which had negative repercussions for capital equipment and commodity producers all over the world (Chart 4). Historically, China has loosened the reins on the financial sector whenever credit growth has fallen towards nominal GDP growth (Chart 5). It appears we have reached this point. Despite a weak seasonally-distorted February print, credit growth has finally accelerated on a year-over-year basis. Chart 4China: The Deleveraging Campaign Had Adverse Effects On Investment Spending Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth We do not expect Chinese credit growth to rise as much as in past releveraging cycles. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 6).3 As long as the central government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. In any case, given that total debt stands at 240% of GDP, even a one percentage-point increase in credit growth would generate a hefty 2.4% of GDP in credit stimulus. The Chinese credit impulse leads imports by about six-to-nine months (Chart 7). This bodes well for global trade in the second half of the year. Chart 6China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth Chart 7Global Trade Will Benefit From A Chinese Reflationary Impulse   A Lull In The Trade War? A de-escalation in the trade war would help matters. As a self-professed master negotiator, Donald Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the agreement was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky for Trump if it had failed to bring down the bilateral trade deficit – an entirely likely outcome given how pro-cyclical U.S. fiscal policy is. At this point, however, Trump could crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized only after he has been re-elected. Thus, the likelihood that Trump will seek to strike a deal has risen. For their part, the Chinese want as much negotiating leverage as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Faster Global Growth And Stronger Domestic Demand Will Benefit Europe Stronger Chinese growth will help the European export sector later this year. The export component of the Chinese Caixin PMI has moved up from its lows. It leads the euro area PMI by about three months. Meanwhile, euro area domestic demand will benefit from a more accommodative fiscal policy and lower bond yields. The decline in bond yields will be especially helpful to Italy. The spike in yields and loss of business confidence following the election of a populist government last March plunged the economy into recession (Chart 8). Now that the 10-year BTP yield has fallen more than 100 bps from its highs, the Italian economy should start to perk up. The ECB will not raise rates this year even if domestic growth speeds up, but the market will probably price in a few rate hikes in 2020 and beyond. This will allow for a modest re-steepening of yield curves in core European bond markets, which should be positive for long-suffering bank profits. Brexit remains a concern. The ongoing saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 9), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 8Italian Bond Yields Are A Headwind No More Chart 9U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win   What Will The Fed Do? Last year’s “Christmas Crash” clearly shifted the Fed’s reaction function in a more dovish direction. We do not expect Jay Powell to raise rates over the next few months, but a reacceleration in global growth is likely to prompt the Fed to tighten anew in December. The Fed will continue raising rates once per quarter in 2020, before accelerating the pace of tightening in 2021 in response to rising inflation. In all, we see the fed funds rate increasing to around 4% by the end of this cycle. This represents nine quarter-point hikes more than the market is currently discounting (Chart 10). We were stopped out of our short fed funds futures trade, but we recommend that clients short the June-2021 fed funds futures or a similar instrument. The U.S. Economy: Great Again Fundamentally, the U.S. economy is on solid ground and can handle higher interest rates. Unlike a decade ago, the housing market is in good shape (Chart 11). The homeowner vacancy rate stands near a record low. Judging by FICO scores, the quality of mortgage lending remains high. The labor market is also firm, with job openings hitting another record high in February (Chart 12). The combination of a healthy housing and labor market is invariably good for consumers. Chart 11U.S. Housing Fundamentals Are Solid Chart 12The U.S. Labor Market Is Firm The personal savings rate currently stands at 7.6%, notably higher than one would expect based on the ratio of household net worth-to-disposable income (Chart 13). A decline in the savings rate would allow consumer spending to increase more quickly than income. With the latter being propped up by rising wages, this will be bullish for consumption. Capital spending intentions have dipped over the past few months, but remain elevated by historic standards (Chart 14). The real nonresidential capital stock has grown by an average of only 1.7% since the start of the recovery, down from 3% in the pre-recession period (Chart 15). A cyclical upswing in productivity growth, rising labor costs, and low levels of spare capacity should all motivate businesses to invest in new plant and equipment. Chart 14Capital Spending Intentions Have Softened, But Remain Elevated Chart 15There Is Room For More U.S. Capital Investment   Corporate Debt: How Much Of A Risk? Chart 16U.S. Corporate Debt Is Not Extreme By Global Standards Corporate debt levels have increased significantly in recent years, while underwriting standards have deteriorated, as evidenced by the proliferation of covenant-lite loans. Nevertheless, the situation is far from dire. Relative to other countries, U.S. corporate debt is quite low (Chart 16). At 143% of GDP, corporate debt in France is twice that of the United States. This is not to suggest that everything is fine in the French corporate sector; but the fact is that France has not had a corporate debt crisis. This signals that the U.S. is not at imminent risk of one either. Netting out cash, U.S. corporate debt as a share of GDP is at the same level it was in 1989, a year in which the fed funds rate was close to nine percent. The ratio of corporate net debt-to-EBITD remains reasonably low. The interest coverage ratio is above its historic average. In addition, corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 17). The corporate sector financial balance – the difference between corporate income and spending – is still in positive territory at 1% of GDP. Every recession in the past 50 years began when the corporate sector financial balance was in deficit (Chart 18). Chart 17U.S. Corporate Debt: How High? Chart 18Corporate Sector Financial Balance Still In Surplus Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players such as pension funds, insurance companies, mutual funds, and ETFs. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 19). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 20). This makes corporate debt less systemically important for the economy.   Chart 19Banks Have Reduced Their Exposure To The Corporate Sector Chart 20U.S. Banks Are Well Capitalized One of the reasons we turned more bullish on risk assets in December was because stocks had plunged and corporate spreads widened without much follow-through in financial stress indices. For example, the infamous TED spread barely budged (Chart 21). Chart 21TED Spreads Are Well Behaved, Indicating No Major Signs Of Financial Stress Everyone Agrees With Larry Given the lack of major imbalances in the U.S. economy, why do investors believe that the Fed cannot raise rates further even though the Fed funds rate in real terms is barely above zero? The answer is that investors appear to have bought into Larry Summers’ secular stagnation thesis, which posits that the neutral rate of interest is much lower today than it was in the past. We have some sympathy for this thesis, but it is important to remember that it is a theory about the long-term determinants of interest rates such as productivity and demographic trends. The theory says little about the cyclical drivers of interest rates, including the amount of spare capacity in the economy, the stance of fiscal policy, credit growth, and wage trends. Earlier this decade, when we were still very bullish on bonds, one could have plausibly argued that the economy needed extremely low interest rates: The output gap was still large; the deleveraging cycle had just begun; home and equity prices were depressed; wage growth was anemic; and fiscal policy had turned restrictive after a brief burst of stimulus during the Great Recession. Far From Neutral? All of the forces mentioned above have either fully or partially reversed course over the past few years. Take fiscal policy as one example. The IMF estimates that the U.S. structural budget deficit averaged 3.3% of GDP in 2014-15. In 2019-20, the IMF reckons the deficit will average 5.6% of GDP. To what extent has easier fiscal policy raised the U.S. neutral rate of interest? Let us conservatively assume that every $1 of additional fiscal stimulus adds $1 to aggregate demand. In this case, fiscal policy has added 2.3% of GDP to aggregate demand over the past five years. Suppose that a one-percentage point increase in aggregate demand raises the neutral rate of interest by 1%, which is in line with the specification of the Taylor Rule that former Fed Chair Janet Yellen favored. This implies that fiscal policy alone has raised the neutral rate by over two percentage points. The discussion above suggests that cyclical factors may have pushed up the neutral rate considerably, even if long-term structural factors are still dragging it down. Since the Fed is supposed to set interest rates with an eye on what is appropriate for the economy over the next year or two, rates may end up staying too low for too long. This will cause the economy to overheat, eventually leading to a surge in inflation. The Inflation Boogeyman The good news is that none of our favorite indicators point to a major imminent inflationary upswing (Chart 22): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s proprietary Pipeline Inflation Indicator has fallen to a two-and-a-half-year low. Wage growth has accelerated, but productivity growth has increased by even more. As a result, unit labor cost inflation has been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 23). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 22No Symptoms of An Imminent Major Inflationary Upswing In The U.S. ... Chart 23... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being At that point, risks are high that inflation will move up. This could force the Fed to start raising rates aggressively in early-2021, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in mid-to-late 2021.   Stay Bullish Global Equities For Now, Turn Defensive Late Next Year Chart 24Analyst Expectations Are Quite Muted The two-stage Fed tightening cycle discussed above – gradual rate hikes starting in December and continuing into 2020, and more aggressive hikes thereafter in response to rising inflation – shapes our investment views over the next few years. The Key Financial Market Forecasts Chart at the beginning of this publication provides a rough sketch of where we think the main asset classes are heading. We suspect that equities and other risk assets will be able to digest the first stage of rate tightening, albeit with heightened volatility around the time when the Fed starts preparing the market for another hike later this year. Unlike last September, earnings estimates are much more conservative. Bottom-up estimates foresee EPS rising by 3.9% in the U.S. and 5.4% in the rest of the world in 2019 (Chart 24). The combination of faster growth, easier financial conditions, and ongoing share buybacks implies some upside to these numbers. Perhaps more importantly, unlike in September, the Fed will only start hiking rates if the economy is performing well. Powell erred in saying that “rates were a long way from neutral” just when the U.S. economy was starting to slow. Had he uttered those words when U.S. growth was still accelerating, investors would have probably disregarded them. Jay Powell won’t make the same mistake again. Rather, he will make a different one: He will let the economy overheat to the point where the Fed finds itself clearly behind the curve and forced to scramble to catch up. The resulting stagflationary environment – where growth is slowing due to a shortage of available workers and inflation is on the upswing – will be toxic for equities and other risk assets. While it is difficult to be precise about timing, we recommend that investors maintain a modestly pro-risk stance over the next 12-to-18 months. However, they should pare back exposure to equities and spread product late next year before the Fed ramps up the pace of rate hikes. Prepare To Temporarily Upgrade International Stocks The U.S. stock market tends to be “low beta” compared to other bourses. If global growth accelerates in the second half of this year, international stocks will outperform their U.S. counterparts. We sold our put on the EEM ETF for a gain of 104% on Jan 3rd, and now recommend being outright long EM equities. We will be looking to upgrade both EM and European equities to overweight in the coming weeks in currency-unhedged terms once we see more confirmatory evidence of a global growth revival. We have mixed feeling about Japanese stocks. Stronger global growth will benefit Japanese multinationals, but firms focused on the domestic market may suffer if the government goes ahead and raises the sales tax in October. We would hold off upgrading Japanese stocks for the time being. At the global sector level, we pared back our defensive tilt earlier this year, after having turned more cautious last summer. We recommend that investors overweight energy and industrials. We are also warming up to financials and materials. The former will benefit from a steepening in yield curves later this year as well as from faster credit growth. The latter will gain from a more robust Chinese economy. We would maintain a neutral allocation to health care, info tech, and communication services. Real estate and utilities will both suffer once bond yields start moving higher. Classically defensive sectors such as consumer staples will also underperform.  Global Bond Yields Likely To Rise Global bond yields are likely to rise over the next 12-to-18 months as growth surprises on the upside. Yields will continue rising into the first half of 2021 as inflation accelerates. Unlike in past risk-off episodes, Treasurys will not provide much of a safe haven in the lead up to the next recession. As noted above, one of the reasons that bond yields are so low today is because the term premium is very depressed. The cumulative effect of Fed bond purchases has probably depressed the term premium, but the bigger impact has stemmed from the fact that investors see Treasurys as an insurance policy against various macro risks. Investors are accustomed to thinking that when an economy slides into recession, equity prices will fall, the housing market will deteriorate, wage gains will recede, job prospects will worsen, but at least the value of their bond portfolio will go up! The problem with this reasoning is that it is only valid when the Fed is hiking rates in response to stronger growth. If the Fed is hiking rates because inflation is getting out of hand, Treasury yields could end up rising while stocks are falling. This was actually the norm between the late-1960s and early-2000s (Chart 25). Chart 25Treasury Yields Could Rise While Stocks Fall If Treasurys lose their safe-haven status, the term premium will move higher. A vicious circle could develop where rising bond yields weaken the stock market, causing investors to flood out of both stocks and bonds and into cash, leading to even higher bond yields and lower equity prices. Investors should maintain a modest short duration stance towards Treasurys over the next 12 months, and then move to maximum underweight duration in mid-2020 as inflation starts to break out. Going long duration will only make sense once the Fed has raised interest rates into restrictive territory and the economy slides into recession. That is not likely to occur until the second half of 2021. Regionally, we favor European, Canadian, Australian, New Zealand, and especially Japanese government bonds over the next 12 months relative to U.S. Treasurys. The U.S. economy is at the greatest risk of overheating. In currency-hedged terms, the 10-year U.S. Treasury yield is among the lowest in the world (Table 1). Japanese 10-year bonds, for example, offer 2.72% in currency-hedged terms, while German bunds command 2.94%. Table 1Bond Markets Across The Developed World   The U.S. Dollar: Heading Towards A Soft Patch Gauging the outlook for the U.S. dollar is a bit tricky. Even though the Fed will only be raising rates gradually over the next 12 months, it will still hike more than what is discounted by markets. With most other central banks still sitting on the sidelines, short-term rate differentials are likely to move in favor of the greenback. That said, aside from Japan, stronger global growth will likely prompt investors to price in a few more rate hikes in other developed economies in 2020 and beyond. Consequently, long-term yield differentials may not widen by as much as short-term differentials. Perhaps more importantly, the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 26). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world (Chart 27). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 26The Dollar Is A Countercyclical Currency Chart 27The U.S. Is A Low-Beta Play On Global Growth If global growth picks up in the back half of this year, the dollar will likely peak in the second quarter and weaken over the remainder of 2019 and into 2020. The dollar’s trajectory may thus follow a similar course to the one in 2017, a year in which the Fed raised rates four times, but the broad trade-weighted dollar nevertheless managed to weaken by 7%. Chart 28The Yen Is A Risk-Off Currency As was the case in 2017, the euro will probably gain ground later this year against the U.S. dollar as will most EM and commodity currencies. However, just as the Japanese yen failed to participate in the rally that most currencies experienced against the dollar in 2017, it will struggle to gain much traction against the greenback. The yen is a “risk-off” currency and thus tends to fall whenever global risk assets rally (Chart 28). In addition, the yen will suffer if global bond yields move up relative to JGB yields later this year, as will likely be the case if the BoJ is forced to prolong its yield curve control regime in the face of tighter fiscal policy. We would go long EUR/JPY on any break below 123. After First Weakening, The Dollar Will Rally Again Late Next Year As the U.S. economy encounters ever more supply-side constraints in 2020, growth will slow and inflation will accelerate. The Fed will respond by hiking rates more quickly than inflation is rising. The resulting increase in real interest rates will put upward pressure on the dollar. In this stagflationary environment, equities will tumble and credit spreads will widen. Tighter U.S. financial conditions will reverberate around the world, causing global growth to decelerate even more than it would have otherwise. This will further turbocharge the dollar. The greenback will only peak once the Fed starts cutting rates in late-2021. Commodities: Getting More Bullish A weaker dollar later this year, along with stronger global growth led by a resurgent China, will be bullish for commodities. BCA’s commodity strategists recommend going long copper at current prices. They are also maintaining their bullish bias towards oil. They expect Brent to average $75/bbl this year and $80/bbl in 2020. Higher U.S. shale output will be offset by delays in building out deepwater export facilities, which will keep supply fairly tight. In past reports, we discussed the merits of buying gold as an inflation hedge. However, we held back from doing so because of our bullish dollar view. Now that we see the dollar peaking over the next few months, we would be buyers of gold on any break below $1275/ounce.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades