Policy

Highlights The consensus view seems to be that equities have to cool off in 2020, even if the danger has passed: Recession fears have dissipated as the yield curve has returned to its normal upward-sloping orientation and US-China trade tensions have abated, but equity return expectations are modest following last year’s bonanza. We agree that a bear market is unlikely, but expect a better year than the consensus, … : Bull markets tend to sprint to the finish line, and if the next recession won’t start before the middle of 2021, 2020 should be another strong year for the S&P 500. … even if earnings growth is uninspiring: Multiples almost always expand when the Fed eases from an already accommodative position, and they expand a lot provided the Fed isn’t easing in response to a market bust or financial crisis. We expect that an inflation revival will take the consensus by surprise, but not this year: We think rising inflation will induce the Fed to bring the curtain down on the expansion and the equity bull market, but not until 2021 at the earliest. Feature We spent the last full week before the holidays meeting with clients and prospects on the west coast. As they look ahead to 2020, investors don’t see any major storm clouds on the horizon, but they sense that stocks have run about as far as they can. We agree with the view that neither a recession nor a bear market awaits, but we expect equities will comfortably outdistance bonds and cash. Forced to take a stand on whether the S&P 500 will beat or fall short of the typical consensus expectation for mid-to-high-single-digit gains,1 we would happily bet the over. As we detailed in our last two publications in December, our optimistic take stems from the deliberately reflationary policy being pursued by the Fed and other major central banks. Restoring inflation expectations to its desired range is job number one for the Fed, and its open commitment to doing so ensures that risk assets will have the monetary policy wind at their back for an extended period. The European Central Bank and the Bank of Japan want to rekindle inflation as well, and can be counted upon to maintain easy policy settings. The rest of the world’s central banks will continue to take their cue from their more influential peers, as no one wants the export headwind of a strong currency in a low-growth environment. Earnings growth has been the primary driver of the 11-year-old equity bull market, not multiple expansion. In our base-case scenario, easy monetary policy will encourage multiple expansion, while a less threatening trade climate, and a modest revival in Chinese aggregate demand, will boost economic activity, especially outside of the US. The modest global acceleration provoked by a pickup in Chinese imports will support earnings growth, so that both equity drivers, earnings and multiples, will be moving in the right direction. We anticipate that at least half of the current bull market’s remaining upside will come from multiple expansion, however. Dismaying as it might be for investors with a value bent, our bull thesis is built on the view that today’s fully-to-somewhat-richly-valued stocks will become overvalued before this market cycle is complete. A Stealth Earnings Boom Skeptics of the efficacy of extraordinarily accommodative monetary policy have decried the current bull market as “manipulated,” fed by monetary steroid injections that have inflated asset prices at the cost of undermining the real economy’s future prospects. The data flatly contradict the skeptics’ claims: since the end of February 2009, consensus forward four-quarter S&P 500 earnings expectations have grown at an annualized rate of 9.6% (Chart 1, middle panel), while the forward multiple has expanded at a 4.6% pace (Chart 1, bottom panel). Growth in forward earnings estimates has accounted for two-thirds of the 14.6% annualized appreciation in the S&P 500 (Chart 1, top panel); multiple expansion has only contributed a third. Chart 1A Great Decade For Earnings A Great Decade For Earnings A Great Decade For Earnings Chart 2DM Growth Has Been Weak DM Growth Has Been Weak DM Growth Has Been Weak Positioning for a valuation overshoot does not inspire as much confidence as positioning for robust earnings growth. US economic growth has been lackluster since the crisis (Chart 2, top panel), and it’s been downright anemic in Europe (Chart 2, middle panel) and Japan (Chart 2, bottom panel). Few investors foresaw potent earnings growth against that macro backdrop, as aggregate corporate revenue growth ought to converge with nominal GDP growth over time. Only margin expansion could deliver S&P 500 earnings growth above and beyond a meager 4% revenue growth base. As early as 2011, US corporate profit margins looked quite stretched (Chart 3), making further expansion seem improbable. After adjusting for the secular decline in effective corporate income tax rates, corporations’ growing share of national income, the expansion of the high-margin financial sector and the secular decline in debt service costs,2 however, history suggested that profit margins still had room to grow. It would be 2018 before they would peak, thanks in part to the 40% cut in the top marginal corporate income tax rate, and the plunge in debt service costs (Chart 4). Compensation is corporations’ single largest expense, though, and the inexorable decline in labor's share of profits was the key driver (Chart 5). Since China’s entry into the WTO, real wages have failed to keep up with productivity gains (Chart 6), dramatizing the shift of profit share from labor to capital. Chart 3Never Say Die Margin Growth, Nourished On... Never Say Die Margin Growth, Nourished On... Never Say Die Margin Growth, Nourished On... Chart 4... Rock-Bottom Rates ... ... Rock-Bottom Rates ... ... Rock-Bottom Rates ... Chart 5... And Labor's Woes ... And Labor's Woes ... And Labor's Woes Chart 6Globalization Has Helped Corporate Profits Globalization Has Helped Corporate Profits Globalization Has Helped Corporate Profits Profit margins contracted across the first three quarters of 2019, with per-share revenue growth topping per-share earnings growth by an average of three percentage points. We expect that real unit labor costs will rise as the pendulum swings back in labor’s direction in line with an extremely tight job market and a slowdown in outsourcing as globalization loses momentum. Revived activity in the rest of the world can offset some margin pressure from a rising wage bill, however, especially if it helps push the dollar lower. And rising wages aren’t all bad for profits, as rising household income leads to rising consumption, and rising consumption boosts corporate revenue growth. In our base-case 2020 scenario, S&P 500 earnings will grow despite accelerating wage growth. Multiples And The Monetary Policy Cycle Although the S&P 500’s forward multiple is already elevated (Chart 7), the historical relationship between monetary policy and equity multiples argues that re-rating is more likely than de-rating going forward. We divide the fed funds rate cycle (Chart 8) into four phases based on the direction of the fed funds rate (higher or lower) and the state of monetary policy (easy or tight). We are currently in Phase IV, when the Fed has most recently eased policy while policy settings were already accommodative. If margins have finally peaked, multiple expansion will have to assume a bigger role in supporting the bull market. Chart 7Elevated But Not Worrisome Elevated But Not Worrisome Elevated But Not Worrisome Chart 8The Fed Funds Rate Cycle The Conventional Wisdom The Conventional Wisdom Since consensus earnings estimates began to be compiled in 1979, forward multiples have shrunk when the Fed hikes rates and expanded when it cuts them (Table 1). The empirical results align with intuition and arithmetic: investors should become stingier when the rate used to discount future earnings rises, and more generous when that rate falls. While we believe that the mid-cycle rate cuts are finished and that the fed funds rate will fall no further over the rest of this bull market, continued multiple expansion does not require continued rate cuts. Phase IV usually ends with an extended stretch when the Fed holds the funds rate at its trough level, but forward multiples do not peak until the final stages of the phase. Making the intuition-and-arithmetic statement more exact, investors become more generous when rates fall, and remain that way until a rate hike is a sure bet. Table 1A Consistent Inverse Relationship The Conventional Wisdom The Conventional Wisdom Away from the last two Phase IVs, when the Fed cut rates in response to the duress issuing from the end of the dot-com mania and the financial crisis, re-rating gains have been significantly larger. Table 2 details the changes in multiples in each Phase IV episode over the last 40 years. Away from the grinding de-rating following the dot-com bust, and the slow re-rating accompanying the tepid post-crisis recovery, multiples have expanded at better than a 17% annualized rate. Voluntary cuts like last summer’s, made when policy is already easy, independent of the imperative to nurse a post-crisis economy back to health, have been awfully good for investors. Table 2Voluntary Cuts Turbocharge Multiples The Conventional Wisdom The Conventional Wisdom There have been only two instances when the starting multiple has been as high as it was at the start of the latest run of rate cuts. As noted above, conditions in the spring of 2001, when the NASDAQ was a year into its eventual two-and-a-half-year slide, and a recession had just begun, bear little resemblance to conditions today. The fall of 1998, when the Fed delivered a rapid-fire 75 basis points of easing to protect the economy from the potential ramifications of Long Term Capital Management’s failure, looks a lot more like last summer. It is not our base case that the latest round of insurance cuts will push forward multiples to dot-com levels, but they do have scope to expand. The Inflation Timetable It remains our high-conviction view that inflation expectations will not return to the Fed’s target levels quickly. Their path has seemed to provide a nearly perfect real-life case study supporting the adaptive expectations framework, which posits that the recent past exerts a powerful influence on near-term expectations about the future. Inflation is way down the list of investors’ concerns because it has been dormant ever since the crisis, just as it was in the mid-‘60s once memories of high postwar inflation had faded. It conversely remained an acute fear for more than a decade after the Volcker Fed turned the tide in the early ‘80s (Chart 9). Multiples have really surged when the Fed has provided discretionary accommodation outside of periods of distress. The slow but meaningful rise in the trimmed mean PCE (Chart 10, top panel) and CPI series3 (Chart 10, bottom panel) should pull core PCE and core CPI higher over time. In the near term, however, the absence of upward momentum in several leading inflation indicators will likely stretch “over time” beyond the first half of the year, if not the whole year. As tight as the labor market is, unit labor costs have not been able to break out of the range that’s contained them for the last five years (Chart 11, top panel); the New York Fed’s Underlying Inflation Gauge has pulled a disappearing act after a seemingly decisive breakout in mid-2018 (Chart 11, middle panel); and the share of small businesses planning price increases has come off the late 2018 boil (Chart 11, bottom panel). Chart 9Recency Bias In Action Recency Bias In Action Recency Bias In Action Chart 10Inflation's Not Dead, ... Inflation's Not Dead, ... Inflation's Not Dead, ...   Chart 11... But It's Still Hibernating ... But It's Still Hibernating ... But It's Still Hibernating Investment Implications We spent the holidays reading up on the history of strikes in the United States and believe a shift in the balance of negotiating power from management to labor may be stirring, as a two-part Special Report will soon explore. Such a shift would render wages much more sensitive to a lack of labor market slack. Upward wage pressure could then filter into consumer prices either via a cost-push or demand-pull framework, as corporations either seek to defend margins from higher input costs or try to implement opportunistic price hikes. Cost-push or demand-pull, many investors seem to be dismissing the potential for an inflation revival, especially the ones we met in northern California, where the deeply held consensus view asserts that looming job destruction from artificial intelligence makes broad wage growth all but impossible. Inflation is not an immediate concern, but we expect it will ultimately spell the end of the bull market and the expansion. Allocating a generous share of long-maturity Treasury exposures to TIPS is an excellent way to protect a portfolio against its eventual re-emergence. We advise investors to maintain at least an equal weight allocation to equities to profit from our view that ongoing multiple expansion will surprise to the upside. Risk-friendly positioning remains appropriate, as long as intensifying US-Iran tensions or other geopolitical conflicts don’t negate the positive impact of reflationary monetary policy.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The ten buy- and sell-side strategists surveyed in Barron’s 2020 Outlook, published December 16th, called for an average gain of 4%. 2 Please see the October 2012 BCA Special Report, “Are US Corporate Profit Margins Really All That High?” available at www.bcaresearch.com. 3 Trimmed-mean inflation series operate like figure skating judging in the Olympics – the top and bottom readings are thrown out, and the mean is calculated from the remaining scores.

Feature Recommended Allocation Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Since BCA published its 2020 Outlook,1 and the December GAA Monthly Portfolio Update,2 nothing has happened to make us fundamentally change our views. We see the global manufacturing cycle rebounding over the coming quarters, but major central banks remaining dovish. This combination of accelerating growth and easy monetary policy should be positive for risk assets. We accordingly continue to recommend an overweight on equities versus bonds, prefer the more cyclical euro zone and EM equity markets over the US, and selectively like credit (particularly the riskier end of the US junk bond universe). In the 2020 Outlook, we laid out a series of milestones that would indicate how our scenario is playing out: whether we need to reconsider it, or whether we should be adding further to risk (Table 1). Here is how those milestones are progressing. Table 1Milestones For The 2020 Outlook Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Chinese growth. Total Social Financing picked up in November (CNY1.75 trillion versus CNY619 billion the previous month) and the most recent hard data (notably retail sales and industrial production) showed improvement. But the momentum of credit creation and activity generally remain weak (Chart 1). We expect that Chinese growth will begin to accelerate in early 2020, due to the lagged effect of monetary stimulus in the first half of last year, and easier fiscal policy. Moreover, December’s annual Central Economic Work Conference pointed to greater government emphasis on growth stability.3 The clampdown on shadow banking also seems to be easing (Chart 2). However, we need to see further signs of Chinese growth accelerating before, for example, we become more bullish on Emerging Markets and commodities. Chart 1Chinese Credit And Activity Remain Weak Chinese Credit And Activity Remain Weak Chinese Credit And Activity Remain Weak Chart 2Clampdown On Shadow Banking Easing? Clampdown On Shadow Banking Easing? Clampdown On Shadow Banking Easing? Trade war. The last-minute agreement to cancel the December 15 rise in US tariffs on Chinese imports represents the “ceasefire” we expected, rather than “phase one” of a more profound agreement. It is still unclear whether previous tariffs will be rolled back (Chart 3). China’s supposed promise to increase imports of US agricultural products from $10 billion a year to $40 billion-$50 billion seems unrealistic. Progress on more fundamental topics such as China’s subsidies for state-owned companies seems far off. For now, President Trump has done enough to minimize the negative impact on the US economy in an election year. But there remains a possibility that trade war reemerges as a risk during 2020. Chart 3How Far The Rollback? How Far The Rollback? How Far The Rollback? Progress against these milestones suggests that our current asset allocation recommendation structure – moderately risk-on, but with hedges against downside risk – is appropriate for now. Global growth. Data confirming the rebound in the manufacturing cycle remain mixed. Economic surprises have generally been positive in the euro zone, but have slipped in the US and Japan, and remain soft in the Emerging Markets (Chart 4). In Germany, the manufacturing PMI slipped back to 43.7 in December, but the Ifo and ZEW surveys both rebounded (Chart 5). There is, however, still little sign that the weakness in manufacturing is spilling over into consumption and services. In Germany, unemployment remains at a record low and wages are strong. In the US, wage growth continues to trend up, and there is no indication in the weekly initial claims data that companies are starting to lay off workers at more than the seasonally normal pace (Chart 6). Market indicators of the cycle are also showing some positive signs. Among commodities, the price of copper – the most cyclical metal – has begun to rise. Chinese cyclical stocks are outperforming defensives. But the US dollar has not yet showed any significant depreciation (Chart 7). Chart 4Economic Surprises Mixed Economic Surprises Mixed Economic Surprises Mixed Chart 5Germany Showing Signs Of Bottoming Germany Showing Signs Of Bottoming Germany Showing Signs Of Bottoming   Chart 6No Problems In The Labor Market No Signs Of Weakening Labor Market No Problems In The Labor Market No Signs Of Weakening Labor Market No Problems In The Labor Market Chart 7Some Positive Signs From The Markets Some Positive Signs From The Markets Some Positive Signs From The Markets     US politics. President Trump’s approval rating has picked up slightly – we warned that its slipping might cause him to get aggressive on trade or foreign policy (Chart 8). Markets might worry at the possibility of “President Warren” given her focus on increased regulation of industries such as finance, energy, and technology. But she has fallen a little in the polls. Even in liberal California (where the primary will be unusually early next year – March 3), she is only level with Biden and Sanders in opinion polls. Our geopolitical strategists see US politics as one of the key geopolitical risks this year,4 but the risk seems subdued for now. Chart 8Trump’s Approval Rating Stable To Rising Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Fed tightening. Expansions usually end when inflation rises, either causing the Fed to raise rates to choke it off, or with the Fed ignoring the inflation and allowing debt and asset bubbles to form. Any signs, therefore, that inflation, or inflation expectations, are rising would signal that we are truly in the “end game”. For now, there are no such signs. US inflation is likely to soften over the next six months, as a result of the economic slowdown and strong dollar. And TIPS breakevens imply the market believes the Fed will miss its inflation target by an average of 80-90 BPs a year over the next decade (Chart 9). The Fed is likely to sound very dovish over the coming year. The review of its monetary policy framework, probably to be announced in July, may result in some sort of “catch-up” policy: under this, if inflation undershoots the Fed’s target, the target automatically rises the following year.5 Its efforts to support the repo market, including short-term Treasury securities purchases of $60 billion a month, will increase the Fed’s balance-sheet, and represent a “mini-QE” (Chart 10). The Fed is likely to be reluctant to turn more hawkish ahead of the presidential election. These dovish moves – and continued accommodative policies from the ECB and Bank of Japan – mean that monetary policy will be supportive for risk assets throughout 2020. Chart 9Inflation Remains Subdued Inflation Expectations Driven By Oil Inflation Remains Subdued Inflation Expectations Driven By Oil Inflation Remains Subdued These milestones suggest, therefore, that our current asset allocation recommendation structure – moderately risk-on, but with hedges (long cash and gold) against downside risk – is appropriate for now. Chart 10A "Mini-QE"? A Mini-"QE"? A Mini-"QE"? Equities: We shifted last month to an underweight on US equities, with an overweight on the euro zone, and neutral on Emerging Markets. The US tends to underperform during upswings in the global manufacturing cycle (Chart 11). Europe looks attractive because of its heavy weighting in sectors we like such as Financials, Autos and Capital Goods. Europe’s returns will also be boosted by the appreciation in the euro and pound that we expect (our equity recommendations assume no currency hedging). For EM, we would turn more positive if we saw a clear pickup in Chinese credit and economic growth. Chart 11US Underperforms When Growth Picks Up US Underperforms When Growth Picks US Underperforms When Growth Picks Chart 12Fed Won't Cut As The Market Expects Fed Won't Cut As The Market Expects Fed Won't Cut As The Market Expects   Fixed Income: Our positive view on global growth implies that long-term rates will rise. We see the US Treasury 10-year yield reaching 2.5% by mid-2020. The market still expects the Fed to cut rates once over the next 12 months. If it stays on hold, as we expect, that slight hawkish surprise would be compatible with a moderate rise in rates (Chart 12). Core euro zone rates might rise by a little less, perhaps by 30-40 BPs, and Japanese government bond yields by 10-15 BPs. We, therefore, continue to recommend a small underweight on duration and an overweight on TIPS which look particularly cheaply valued. Within credit, our preferences are for European investment grade (not as expensive as in the US, and with the ECB buying corporate debt again) and the lower end of the US junk-bond universe (since CCC-rated bonds missed out on 2019’s rally). In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued, and with speculative positions long the dollar. Currencies: In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued (Chart 13), and with speculative positions long the dollar (Chart 14). But its performance is likely to vary depending on the currency pair. Our FX strategists expect the dollar to weaken to 1.18 against the euro and 1.40 against the pound over the next 12 months, and even more against currencies such as the NOK, SEK, and AUD.6 But the dollar is likely to strengthen against the yen (an even more counter-cyclical currency) and against currencies in EM, where central banks will continue to cut rates and inject liquidity aggressively to support their economies. Chart 13Dollar Looks Expensive... Dollar Looks Expensive... Dollar Looks Expensive... Chart 14...And Speculators Are Long Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones     Commodities: Supply in the oil market remains tight, with OPEC deepening its production cuts to 1.7 million barrels/day. The crude oil price was held down in 2019 by weakening demand, which should recover along with the cycle in 2020 (Chart 15). Our energy strategists expect Brent to average $67 a barrel in 2020 (compared to $66 now), with WTI $4 lower. Metal prices could rise in 2020 as Chinese growth recovers and the US dollar depreciates – the two most important factors that drive them (Chart 16). Given the uncertainty over both, we remain neutral for now, but would turn more positive (including on commodity-related assets, such as Australian or EM equities) if we see clear signs of their moving in the right direction. We see gold as a good downside hedge in a world of ultra-low interest rates, especially since central banks may allow inflation to overshoot over the coming years. Chart 15Supply/Demand Balance Points To Higher Oil Price Markets Will Tighten In 2020 Supply/Demand Balance Points To Higher Oil Price Markets Will Tighten In 2020 Supply/Demand Balance Points To Higher Oil Price Chart 16Metals Are Driven By The Dollar And China Metals Are Driven By The Dollar And China Metals Are Driven By The Dollar And China   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1 Please see "Outlook 2020: Heading Into The End Game," dated 22 November 2019, available at bca.bcaresearch.com. 2 Please see "GAA Monthly Portfolio Update: How To Position For The End Game," dated 2 December 2019, available at gaa.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Year-End Tactical Upgrade," dated 18 December 2019, available at cis.bcaresearch.com 4 Please see Geopolitical Strategy "Strategic Outlook: 2020 Key Views: The Anarchic Society," dated 6 December 2019, available at gps.bcaresearch.com 5 For example, if the Fed's inflation target is 2% but inflation is only 1.7% one year, the target would automatically rise to 2.3% the following year. 6 Please see Foreign Exchange Strategy, "2020 Key Views: Top Trade Ideas," dated December 13, 2019, available at fes.bcaresearch.com GAA Asset Allocation  

Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All It’s A Small World After All It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Table 1 Top US Sector Investment Ideas For The Next Decade Top US Sector Investment Ideas For The Next Decade China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Software Is Eating The World Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector (Chart 14). If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart II-1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart II-1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The small cap preference is a secular view with a time horizon that spans the next decade. Chart II-2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart II-2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Chart II-3 shows reconstructed S&P 500 profits and sales data back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated. Chart II-3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart II-4). Chart II-4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are often business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart II-4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart II-4). Buy or add software stock exposure on any weakness with a 10-year investment time horizon. Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful Chart II-5It's A Small World After All It's A Small World After All It's A Small World After All While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart II-5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart II-6). Chart II-6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more mainstream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. We have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. The caveat? President Trump's recent short-term deal with China could set back the de-globalization theme. But our geopolitical strategists do not anticipate it to be a durable deal, and they also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress Chart II-7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart II-7). The US Equity Sector service's October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s.1 These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Table II-1 January 2020 January 2020 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact, SIPRI data on global military spending by 2030 (Table II-1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries of rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and who that data is shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Chart II-8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Tack on the threat of federal regulation and this represents another major headwind for profits and margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart II-8)! This is unsustainable and they will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless, increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Chart II-9Software Is Eating The World Software Is Eating The World Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart II-9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart II-9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate to gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the US Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart II-10). Chart II-10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term, we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and related industries. Furthermore, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership theme noted in this report leads us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). Chart II-11Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money, it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart II-11). Investors seeking long-term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.2 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind that as reported in the FT, “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last week, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions, it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart II-12). Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we expect to play out, and centered our recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart II-13). Chart II-12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Chart II-13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles   Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart II-13). However, if the four decade bull market in Treasurys is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart II-14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart II-14Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Chart II-15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising US twin deficits, this will continue as well. In a nutshell, there has been hardly a time in recent history when the twin deficits in the US were rising and the dollar was in a secular uptrend (Chart II-15). Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist Matt Gertken Geopolitical Strategist Marko Papic Chief Strategist, Clocktower Group Chester Ntonifor Foreign Exchange Strategist Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see US Equity Strategy Special Report "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com 2 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

As 2019 draws to a close, we thank you for your ongoing readership and support. We wish you and your loved ones a happy holiday season and all the best for a healthy and prosperous 2020. Highlights We explore the principal risks to our optimistic 2020 outlook. Trade and the 2020 US Presidential election remain potential landmines. A stronger dollar would tighten global financial conditions and be deflationary. Credit market tremors would end buybacks. Stronger-than-expected inflation would force a cycle-ending Federal Reserve tightening. Weaker-than-expected inflation would first allow for larger bubbles to form at the expense of a more painful recession and deeper a bear market down the road. Hedging against those risks warrants overweighting cash, TIPs and gold. Feature Chart I-1Timing is Ripe For A Recovery Timing is Ripe For A Recovery Timing is Ripe For A Recovery As always, this year’s visit from Ms. and Mr. X was thought-provoking and generated diverse investment ideas.1 While we did not share Mr. X’s fears, his caution may be justified because an aging business cycle, elevated equity multiples and extremely expensive government bonds do not mesh with pro-risk portfolio positioning. With this in mind, we will explore the greatest risks to our positive market outlook, which include politics, the US dollar, problems in the credit market, a quicker resumption of inflation and lower inflation. The Central Scenario To understand how these five risks affect our central thesis, let’s review the key views and themes that underpin our bullish outlook. BCA expects global economic activity to recover in 2020. First, the global inventory contraction is advanced, which increases the chance that the manufacturing cycle will track its usual pattern of an 18-month decline followed by an 18-month acceleration (Chart I-1). Secondly, Chinese policymakers are putting a floor under domestic economic activity and the stabilization in credit growth and the climbing fiscal impulse already augur well for global growth (Chart I-2). Thirdly, global liquidity is in a major upswing, thanks to easing by central banks around the world (Chart I-3). Finally, the trade détente between the US and China agreed last week reduces the odds of a destructive trade war. Chart I-2China's Policy Turnaround China's Policy Turnaround China's Policy Turnaround Chart I-3Easing Abound! Easing Abound! Easing Abound!   US monetary policy will remain accommodative next year. US inflation will remain subdued in the first half of 2020 in response to both the global growth slowdown underway since mid-2018 and the lagged effect of a stronger dollar. Moreover, Fed policy will remain sensitive to inflation expectations. According to BCA’s US Bond Strategy’s model, it could take an extended overshoot in realized inflation before inflation expectations move back to the 2.3% to 2.5% range consistent with achieving a 2% inflation target (Chart I-4). Thus, the Fed will remain on pause for all of 2020. BCA’s positive outlook depends on both China and the US respecting their trade truce. In this context, the dollar will depreciate. The USD is a countercyclical currency and typically suffers when global economic activity rebounds, especially if inflation remains tame (Chart I-5). This behavior is due to the low share of the US economy dedicated to manufacturing and exports, which makes the US less sensitive to global trade and industrial activity. Moreover, when the world economy strengthens, safe-haven flows that boost the dollar in times of duress reverse, which accentuates the selling pressure on the USD. Chart I-4Realized Inflation Will Guide Expectations Realized Inflation Will Guide Expectations Realized Inflation Will Guide Expectations Chart I-5The Dollar Won't Respond Well To Stronger Global Growth The Dollar Won't Respond Well To Stronger Global Growth The Dollar Won't Respond Well To Stronger Global Growth   Global bond prices will be another victim of an improving economic outlook. Global safe-haven securities are extremely expensive and investors are too bullish toward this asset class (Chart I-6). This puts government bonds at risk in the face of positive economic surprises. However, the upside in Treasury yields will be capped between 2.25 and 2.5% because the Fed will be cautious about lifting rates. This move will likely be led by inflation expectations. As a result, we favor TIPs over nominal Treasurys. Chart I-6Safe-Haven Yields Have Upside Safe-Haven Yields Have Upside Safe-Haven Yields Have Upside Chart I-7Investors Aren't Feeling Exuberant About Earnings Growth Investors Aren't Feeling Exuberant About Earnings Growth Investors Aren't Feeling Exuberant About Earnings Growth   Equities will outperform bonds. The S&P 500 is trading at 18-times forward earnings and 2.3-times sales. However, those elevated multiples are due to depressed risk-free rates. Long-term growth expectations embedded in stock prices are only 1%, toward the bottom of this series’ historical distribution (Chart I-7). Therefore, investors are not particularly optimistic on the long-term prospects of per-share earnings. This lack of euphoria implies that stocks are not as expensive as bonds, and that if yields climb because of improving global economic activity, then equities will outperform bonds. Moreover, with a backdrop of easy money and no recession forecast until 2022, the timing still favors positive returns for equities in the coming 12 to 18 months (Table I-1).   Table I-1The End Game Can Be Rewarding January 2020 January 2020 Finally, we favor European equities over US stocks. This regional slant is as much a reflection of the better value offered by European stocks as it is of their sector composition. European stocks are trading at a forward PE of 14, implying an equity risk premium of 846 basis points versus 546 basis points in the US. Moreover, our preference for industrials, energy and financials favors European equities (Table I-2). Additionally, European banks are our favorite equity bet worldwide because they trade at a price-to-book ratio of only 0.6 and the drivers of their return on tangible equity are perking up (Chart I-8). Table I-2Europe: Overweight In The Right Sectors January 2020 January 2020 Chart I-8Brightening Prospects For Euro Area Banks Brightening Prospects For Euro Area Banks Brightening Prospects For Euro Area Banks     Risk 1: Politics BCA’s positive outlook depends on both China and the US respecting their trade truce. However, the two countries are long-term rivals and the rising geopolitical power of China relative to the US will cause tensions to escalate in the coming decades (Chart I-9). This also suggests that China and the US are highly unlikely to ever have an agreement that fully covers intellectual property transfers. Chart I-9China/US Tensions Are Structural China/US Tensions Are Structural China/US Tensions Are Structural The US could still renege on the “Phase One” deal. President Trump faces an election in 2020 and the majority of Democratic hopefuls are also hawkish on China. If Trump’s low approval rating does not improve soon (Chart I-10), he could become a more war-like president, in the hope that electors will rally around the flag. A renewed trade war would hurt business sentiment and undermine consumer spending (Chart I-11). A bellicose approach to international relations, especially on trade, would spark another spike in global policy uncertainty that will hurt global capex intentions. Meanwhile, companies could cut employment, which would weigh on household incomes. A rising unemployment rate could also hurt household confidence, reinforcing the slowdown in consumer spending. This would guarantee an earlier recession. Stocks would decline along with global government bond yields. Chart I-10President Trump Can Still Make It January 2020 January 2020 Chart I-11Households On The Edge Households On The Edge Households On The Edge   The US election creates an additional political risk. Democratic candidates are touting higher corporate taxes, a wealth tax, a greater regulatory burden, antitrust actions, and so on. These policies are worrisome to corporate leaders and business owners. For the time being, our Geopolitical Strategy team favors a Trump victory in 2020 (Chart I-12).2 However, if his odds deteriorate significantly, then business executives would likely curtail capex and hiring. This could also result in a US recession that would invalidate our central scenario for 2020. Chart I-12Our Model Still Favors President Trump January 2020 January 2020 Risk 2: A Strong Dollar A strong US dollar would hurt growth. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. The dollar affects the global cost of capital. Both advanced economies and emerging markets have USD-denominated foreign currency debt totaling around $6 trillion each. A strong USD raises the cost of servicing this large debt load, which could force borrowers to curtail their spending. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. Despite our conviction that the US dollar will depreciate in 2020, the following factors may invalidate our thesis: The USD still possesses the highest carry in the G10. When the dollar is supported by some of the highest interest rates in the G10, it often continues to rally (Chart I-13). Chart I-13The Dollar Offers An Elevated Carry The Dollar Offers An Elevated Carry The Dollar Offers An Elevated Carry The global growth rebound may be led by the US. If the US leads the rest of the world higher, then rates of return in the US would climb quicker than in the rest of the world. The resulting capital inflows would bid up the dollar. The shortage of USDs in offshore markets may flare up again. The September seize-up in the repo market was a reminder that because of the Basel III rules, global banks have a strong appetite for high-quality collateral and reserves. This generates substantial demand for the USD, which could put upward pressure on its exchange rate. The US dollar is a momentum currency. Among the G10 currencies, the USD responds most strongly to the momentum factor (Chart I-14).3 The dollar’s strength in the past 18 months could initiate another wave of appreciation. The dollar may not be as expensive as suggested by purchasing power parity (PPP) models. According to PPP estimates, the trade-weighted dollar is 24.2% overvalued. However, according to behavioral effective exchange rate models (BEER), the dollar may be trading closer to its fair value (Chart I-15). Chart I-14The Dollar Is A Momentum Currency January 2020 January 2020 Chart I-15Is The Dollar Expensive? Is The Dollar Expensive? Is The Dollar Expensive?   Why are the five items listed above risks for the dollar, but not our central scenario? Regarding the dollar’s carry, in 1985, 1999, and 2006, the US still offered some of the highest short-term interest rates among advanced economies, nevertheless the dollar began to depreciate. In those three instances, an acceleration in foreign economic activity relative to the US was the key culprit behind the USD’s weakness. In 2020, we expect foreign economies to lead the US higher. Since mid-2018, the manufacturing sector has been at the center of the global slowdown. But now, inventory and monetary dynamics point towards a re-acceleration in manufacturing activity. The US was the last nation to be hit by the growth slowdown; it will also be the last to reap a dividend from the recovery. The marginal buyers of US equities have been US firms. On the danger created by the dollar and the collateral shortage, the Fed is tackling the lack of excess reserves head-on by injecting $60 billion per month of reserves via its asset purchases. Moreover, the US fiscal deficit, which is tabulated to reach $1.1 trillion in 2020, will add a similar amount of dollars to the pool of high-quality collateral around the world, especially as the US current account deficit is widening anew. On the momentum tendency of the USD, the dollar’s momentum seems to be petering off. A move in the Dollar Index below 96 would indicate a major change in the trend for the DXY. Finally, estimates of a currency’s fair value based on BEER fluctuate much more than those based on PPP. If the global growth pick-up allows foreign neutral rates to increase relative to the US over the coming 12 to 24 months, then the dollar’s BEER equilibrium will likely converge toward PPP, putting downward pressure on the USD. Risk 3: Credit Market Tremors A credit market selloff is not our base case, but it would be damaging to risk assets. A deterioration in credit quality would be the main culprit behind a widening in credit spreads. Our Corporate Health Monitor already shows that the credit quality of US firms is worsening (Chart I-16). Moreover, the return on capital of the US corporate sector is rapidly deteriorating. Accentuating these risks, US profit margins have begun to decline because a tight labor market is exerting an upward pull on real unit labor costs (Chart I-17). Furthermore, the near-total disappearance of covenants in new corporate bond issuance increases the risks to lenders and will likely depress recovery rates when a default wave emerges. Chart I-16Deteriorating Fundamentals For US Corporates Deteriorating Fundamentals For US Corporates Deteriorating Fundamentals For US Corporates Chart I-17A Tight Labor Market Is Biting Into Margins A Tight Labor Market Is Biting Into Margins A Tight Labor Market Is Biting Into Margins     Widening credit spreads would signal a darkening economic outlook. Historically, wider spreads have been an excellent leading indicator of recessions (Chart I-18). Wider spreads have a reflexive relationship with the economy: they reflect anticipation of rising defaults by investors, but they also represent a price-based measure of lenders’ willingness to extend credit. Therefore, wider spreads force open the underlying cracks in the economy by depriving funds to weak borrowers. The resulting deterioration in capex and hiring would prompt a decline in consumer confidence and spending, ultimately leading to a recession. Chart I-18Widening Spreads Foreshadow Recessions Widening Spreads Foreshadow Recessions Widening Spreads Foreshadow Recessions Chart I-19Who Is Buying Stocks? Businesses! Who Is Buying Stocks? Businesses! Who Is Buying Stocks? Businesses! US equities may prove to be even more sensitive to the health of the credit market than in previous cycles. The marginal buyers of US equities have been US firms, which have engaged in equity retirements totaling $16.5 trillion since 2010. Since that date, pension plans, foreigners and households have sold a total of $7.7 trillion in US equities (Chart I-19). Both internally generated cash flows and borrowings have allowed for a decline in the equity portion of funding among US firms. Therefore, a weak credit market would hurt equities because a recession would depress firms’ free cash flows and hamper the capacity of firms to buy back their shares. Finally, the tendency of US firms to borrow to buy back their shares means that newly issued debt has not been matched by as much asset growth as in previous cycles. Therefore, borrowing is not backed by the same degree of collateral as in past cycles. If the credit market seizes up, then default and recovery rates will suffer even more than suggested by our corporate health monitor. The VIX will blow up and equities could suffer. Higher US inflation is potentially the most important downside risk for next year. While a widening in credit spreads would have a profound impact on stocks, it is unlikely to materialize when the Fed conducts a very accommodative monetary policy and global growth recovers. Risk 4: Higher Inflation Chart I-20The US Labor Market Is Tight The US Labor Market Is Tight The US Labor Market Is Tight Higher US inflation is potentially the most important downside risk for next year as it would catalyze the aforementioned dangers. Inflation could surprise to the upside because the labor market is tight. At 3.5%, the unemployment rate is well below equilibrium estimates that range between 4.1% and 4.6%. Small firms are increasingly citing their inability to find qualified labor as the biggest constraint to expand production. In the Conference Board Consumer Confidence survey, the number of households reporting that jobs are easily procured is near a record high relative to those preoccupied by poor job prospects. Finally, the voluntary quit rate is at 2.3%, a near record high (Chart I-20). Core PCE remains at only 1.6% year-on-year, but investors should recall the experience of the late 1960s. Through the 1960s, the labor market was tight, yet core inflation remained between 1% and 2%. However, in 1966, inflation suddenly accelerated to 4% before peaking near 7% in 1970. Some inflation dynamics warrant close monitoring. The three-month annualized rate of service inflation excluding rent of shelter has already surged to 4.5% and the same metric for medical care inflation stands at 5.9%. A continued tightening in the labor market could solidify a broadening of these trends because a rising employment-to-population ratio for prime-age workers points toward stronger salaries and ultimately higher domestic demand (Chart I-21). A very weak dollar would also allow this scenario to develop. Chart I-21Household Income Growth Will Accelerate January 2020 January 2020 A sudden flare in inflation would prompt an abrupt tightening in liquidity conditions that would be lethal for the economy. An out of the blue surge in CPI would likely cause a swift reassessment of inflation expectations by households and investors. Under these circumstances, the Fed could tighten monetary policy much faster than we currently envision. If interest rate markets are forced to price in a prompt removal of monetary accommodation, Treasury yields could easily spike above 3.5% by year end, which would hurt both the economy and the expensive equity market. If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. For now, this scenario remains a tail risk because the recent economic slowdown will probably continue to act as a dampener on US inflation in the first half of the year. Additionally, we do not expect the USD to collapse by 40% and fan inflation and inflation expectations, as occurred from 1985 to 1987. Instead, inflation expectations are much better anchored than they were in either the 1960s or 1980s, decreasing the risk that the Fed will suddenly have to tighten policy. Risk 5: Weaker-Than-Expected Inflation Chart I-22An Aggressive BoJ Did Not Achieve Inflation An Aggressive BoJ Did Not Achieve Inflation An Aggressive BoJ Did Not Achieve Inflation The last risk is paradoxical, but it is the one with the highest probability. It is paradoxical because it involves greater upside for stocks next year than we currently anticipate, but at the expense of a much deeper bear market in the future. The labor market may be tight, but Japan’s experience cautions us against extrapolating that inflation is necessarily around the corner. In Japan, the unemployment rate has been below 3.5% since 2014 and minimal domestically generated inflation has emerged. Inflation excluding food and energy remains at a paltry 0.7% year-on-year, even as the Bank of Japan has kept the policy rate at -0.1% and expanded its balance sheet from 20% of GDP in 2008 to 102% today (Chart I-22). If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. Central banks are currently toying with their inflation targets, discussing allowing inflation overshoots and displaying deep paranoia in the face of deflation. By weighing on inflation expectations, low realized inflation would nail policy rates around the world at currently depressed levels or even lower. Chart I-23Bubbles Destroy Long-Term Return On Capital Bubbles Destroy Long-Term Return On Capital Bubbles Destroy Long-Term Return On Capital In this context, bond yields would have even more limited upside than we envision and risk assets could experience higher multiples than today. In other words, we would have a perfect scenario for another stock market bubble. Vulnerability would escalate as valuations balloon and the perceived risk of monetary tightening dissipates from both investors’ and economic agents’ minds. Elevated asset valuations portend lower long-term expected returns (Chart I-23) and a larger share of the capital stock would become misallocated. Ultimately, the stimulative impact of such a bubble would create its own inflationary pressures. Consumers and companies would accumulate more debt and cyclical spending would rise (Chart I-24). In the end, the Fed would raise rates more aggressively, but the economy would be more vulnerable to those higher rates. Chart I-24Higher Cyclical Spending Creates Vulnerabilities Higher Cyclical Spending Creates Vulnerabilities Higher Cyclical Spending Creates Vulnerabilities Therefore, we would see a larger recession and, because assets are more expensive, a greater decline in prices. This would be extremely destabilizing for the global economy, potentially much more so than if a recession were to emerge today. Moreover, since the resulting slump would be yet another balance-sheet recession, it would likely entail a lack of capacity by central banks to reflate their economies. Conclusion The scenarios above are all risks to our benign view for 2020. The first four represent downside threats for assets next year, but the last one (weaker-than-expected inflation) entails upside potential to our forecast next year with significantly more painful results down the line. These risks are important to consider when protecting our portfolio, which has a pro-cyclical bias. It is overweight stocks, underweight bonds, and favors cyclical equities as well as foreign bourses at the expense of the US. BCA’s Global Asset Allocation service recently published an article on safe havens, which studied the profile of risk assets under various circumstances.4 Treasurys normally are the best safe haven, however, at current levels of yields, this benefit will be small compared with previous cycles. Instead, we favor an overweight position in cash, TIPs and gold. The best defense against short-term gyrations is to think about long-term strategic asset allocation. In this regard, this month’s Special Report – co-authored with BCA’s Equity, Geopolitical and Foreign Exchange Strategists, and Marko Papic, Chief Strategist at Clocktower Group – discusses our top sector calls for the upcoming decade. Mathieu Savary Vice President The Bank Credit Analyst December 20, 2019 Next Report: January 30, 2020   II. Top US Sector Investment Ideas For The Next Decade Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart II-1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart II-1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The small cap preference is a secular view with a time horizon that spans the next decade. Chart II-2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart II-2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Chart II-3 shows reconstructed S&P 500 profits and sales data back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated. Chart II-3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart II-4). Chart II-4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are often business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart II-4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart II-4). Buy or add software stock exposure on any weakness with a 10-year investment time horizon. Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful Chart II-5It's A Small World After All It's A Small World After All It's A Small World After All While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart II-5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart II-6). Chart II-6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more mainstream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. We have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. The caveat? President Trump's recent short-term deal with China could set back the de-globalization theme. But our geopolitical strategists do not anticipate it to be a durable deal, and they also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress Chart II-7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart II-7). The US Equity Sector service's October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s.5 These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Table II-1 January 2020 January 2020 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact, SIPRI data on global military spending by 2030 (Table II-1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries of rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and who that data is shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Chart II-8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Tack on the threat of federal regulation and this represents another major headwind for profits and margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart II-8)! This is unsustainable and they will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless, increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Chart II-9Software Is Eating The World Software Is Eating The World Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart II-9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart II-9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate to gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the US Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart II-10). Chart II-10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term, we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and related industries. Furthermore, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership theme noted in this report leads us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). Chart II-11Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money, it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart II-11). Investors seeking long-term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.6 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind that as reported in the FT, “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last week, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions, it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart II-12). Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we expect to play out, and centered our recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart II-13). Chart II-12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Chart II-13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles   Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart II-13). However, if the four decade bull market in Treasurys is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart II-14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart II-14Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Chart II-15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising US twin deficits, this will continue as well. In a nutshell, there has been hardly a time in recent history when the twin deficits in the US were rising and the dollar was in a secular uptrend (Chart II-15). Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist Matt Gertken Geopolitical Strategist Marko Papic Chief Strategist, Clocktower Group Chester Ntonifor Foreign Exchange Strategist Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts With a breakthrough in trade talks and Fed officials changing their language to suggest that policy will remain accommodative until inflation meaningfully overshoots 2%, the S&P 500 decisively broke out. Because it eases global financial conditions and boosts the profit outlook, the recent breakdown in the dollar should fuel the equity rally. Tactically, the S&P 500 may have overshot the mark, but on a cyclical basis, stronger growth and an easy Fed will propel US and global stocks higher. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. However, our Willingness-to-Pay (WTP) indicator for the US and Japan continues to improve. In Europe, this indicator has finally hooked up. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Moreover, the pickup in Europe suggests that European stocks are increasingly ripe to outperform their US counterparts. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth remains very strong as global central banks have adopted strongly dovish slants. Additionally, a Fed that will allow inflation to overshoot before tightening policy is adding to this supportive monetary backdrop. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Finally, our BCA Composite Valuation index is suggesting that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. As a result, our Speculation Indicator remains in the neutral zone. 10-year Treasurys yields are becoming slightly less expensive, however, they are no bargain. Moreover, our Composite Technical Indicator is quickly moving away from overbought territory but has yet to flash oversold conditions, indicating that yields are roughly half way through their move. The strengthening of the Commodity Index Advance/Decline line and higher natural resource prices further confirm the upside for yields. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Small signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and IFO surveys, or the acceleration in Singapore’s container throughput growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24% relative to its purchasing-power parity equilibrium. Additionally, our Composite Technical Indicator is quickly deteriorating after having formed a negative divergence with the Greenback’s level. Since the dollar is a momentum currency, this represents a dark omen for the USD. In fact, we continue to believe that a breakdown in the dollar will be the clearest signal that global growth is rebounding for good. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart II-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart II-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart II-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Special Report "US Election 2020: Civil War Lite," dated November 22, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 4 Please see Global Asset Allocation Special Report "Safe Haven Review: A Guide To Portfolio Protection In The 2020s," dated October 29, 2019, available at gaa.bcaresearch.com. 5 Please see US Equity Strategy Special Report "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com 6 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

An analysis on Ukraine is available below.   Highlights A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and chase this EM rally. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. However, it seems the market is operating on a “buy now, ask questions later” principle. Therefore, we are initiating a long position in the EM equity index as of today. Despite the potential for higher EM share prices in absolute terms, we are still reluctant to upgrade EM versus DM stocks. The basis is that EM corporate profits will continue lagging those in DM. Feature We could be in for a replay of the 2012-2014 DM equity rally, where EM stocks rebounded in absolute terms but massively underperformed DM on a relative basis. Chart I-1EM Share Prices: In Absolute Terms And Relative To DM EM Share Prices: In Absolute Terms And Relative To DM EM Share Prices: In Absolute Terms And Relative To DM EM share prices have spiked on the announcement of a trade truce between the US and China. As a result, our buy stop at 1075 on the EM MSCI Equity Index has been triggered, and we are initiating a long position in EM stocks as of today (Chart I-1, top panel). That said, we are still reluctant to upgrade EM versus DM stocks. Regardless of the direction of the market (bull, bear or sideways), EM share prices will likely underperform the global equity benchmark. As we discussed in our report, the primary risk to our view has been that EM share prices get pulled higher as a result of rallying DM markets. Nevertheless, our fundamental assessment remains that EM corporate profits will lag those in DM, heralding EM relative equity underperformance. In fact, we could be in a replay of the 2012-2014 DM equity rally where EM stocks massively underperformed (Chart I-1, bottom panel), as we elaborated in our November 28 report. In this report, we review the indicators that support a bullish stance, the ones that are inconclusive and those that are not confirming the current rally in China-plays in general and EM risk assets in particular. Bullish Liquidity And Technical Settings The following points have led us to give benefit of the doubt to recent market action and to chase this rally: The global liquidity backdrop appears to be conducive for higher share prices. Global narrow and broad money growth have accelerated (Chart I-2). That said, a caveat is in order: These money measures do not always strongly correlate with both global share prices and the global business cycle. There are numerous times when they gave a false signal or were too early or late at turning points. Chart I-2Global Narrow And Broad Money: A Useful But Not Always Reliable Indicator Global Narrow And Broad Money: A Useful But Not Always Reliable Indicator Global Narrow And Broad Money: A Useful But Not Always Reliable Indicator   The technical profile of EM equities is rather bullish. As shown on the top panel of Chart I-1 on page 1, EM share prices have found a support at their six-year moving average. When a market fails to break down below its long-term technical support line, odds are that a major bottom has been reached, and the path of the least resistance is up. The reason we look at these long-term (multi-year) moving averages is because they have historically worked very well for key markets like the S&P 500 and 10-year US Treasury bond yields (Chart I-3A & I-3B). Chart I-3AThe Reason Why We Use Multi-Year Moving Averages The Reason Why We Use Multi-Year Moving Averages The Reason Why We Use Multi-Year Moving Averages Chart I-3BThe Reason Why We Use Multi-Year Moving Averages The Reason Why We Use Multi-Year Moving Averages The Reason Why We Use Multi-Year Moving Averages   As another positive development, both EM share prices in local currency terms and the EM equity total return index in US dollar terms have bounced from their three-year moving averages (Chart I-4). Chart I-4A Bullish Chart Formation For EM Equities A Bullish Chart Formation For EM Equities A Bullish Chart Formation For EM Equities In addition, when a market does not drop below its previous top, this creates a bullish chart configuration (Chart I-4). This seems to be the case with EM share prices currently. Bottom Line: A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and to chase this rally. Inconclusive Indicators It is rare that all types of indicators – directional market, business cycle, valuation and technical – all line up together to convey the same investment recommendation. Below we present the market indicators and signals that we have been watching to get confirmation of sustainability in the bull market in EM risk assets, commodities and global cyclical equity sectors. They are still inconclusive: The US broad trade-weighted dollar has recently sold off, but it has not broken down technically (Chart I-5). A decisive relapse below its 200-day moving average will signify that the greenback has entered a major bear market. The latter would be consistent with a sustainable and extended bull market in EM risk assets, commodities and global cyclical equity sectors.  Chart I-5The US Dollar Has Fallen But Not Broken Down The US Dollar Has Fallen But Not Broken Down The US Dollar Has Fallen But Not Broken Down Chart I-6Indecisive Signals From Commodities And Commodity Currencies bca.ems_wr_2019_12_19_s1_c6 bca.ems_wr_2019_12_19_s1_c6   Even though copper prices have recently rebounded, they have not yet broken above their three-year moving average (Chart I-6, top panel). The latter can be viewed as the neckline of the head-and-shoulders pattern that has formed in recent years. The same holds true for the overall London Metals Exchange Industrial Metals Price Index, as well as our Risk-On/Safe-Haven currency ratio1 (Chart I-6, middle and bottom panels). Barring a decisive break above their three-year moving averages, the jury is still out on the durability of the rally in commodities prices and EM/China plays.   Finally, global industrial share prices and US high-beta stocks have advanced to their 2018 highs, but have not yet broken out (Chart I-7). The same is true for the euro area aggregate stock index in local currency terms (Chart I-8). A decisive breakout above these levels will confirm that global equities in general and cyclical segments in particular are in an enduring bull market. Chart I-7Decisive Breakouts Here Are Needed To Confirm The EM Rally Decisive Breakouts Here Are Needed To Confirm The EM Rally Decisive Breakouts Here Are Needed To Confirm The EM Rally Chart I-8European Share Prices Are At A Critical Juncture European Share Prices Are At A Critical Juncture European Share Prices Are At A Critical Juncture   Bottom Line: Several cyclical and high-beta segments of global financial markets are at a critical juncture. A decisive breakout from these key technical levels is required for us to uphold that EM risk assets and global cyclical plays are in a medium-term bull market. The Eye Of The Storm? There are a number of leading indicators and market signals that do not corroborate the common narrative of a sustainable improvement in global manufacturing/trade in general and China’s industrial cycle in particular: First, China’s narrow and broad money growth appear to be rolling over (Chart I-9). Notably, the money impulses lead the credit impulse, as illustrated in Chart I-10. Consequently, we expect the credit impulse – which is the main indicator currently portraying a revival in the Chinese economy as well as in the global business cycle – to roll over in early 2020. Chart I-9China: Narrow And Broad Money Growth Are Rolling Over bca.ems_wr_2019_12_19_s1_c9 bca.ems_wr_2019_12_19_s1_c9 Chart I-10China: Money Impulses Are Coincident Or Lead Credit Impulse bca.ems_wr_2019_12_19_s1_c10 bca.ems_wr_2019_12_19_s1_c10   This entails that the recent tentative improvements in China’s manufacturing, its imports and global trade will not be sustained going forward. Crucially, China’s narrow money (M1) growth point to the lack of a cyclical upturn in EM corporate profits in H1 2020 (Chart I-11). In short, EM listed companies’ profit growth rate stabilizing at around -10% is not a recovery. Second, government bond yields in both China and Korea are not corroborating a revival in their respective business cycles (Chart I-12). Chart I-11EM Corporate Profit Growth To Remain Negative In H1 2020 bca.ems_wr_2019_12_19_s1_c11 bca.ems_wr_2019_12_19_s1_c11 Chart I-12Asian Rates Are Not Confirming A Recovery Asian Rates Are Not Confirming A Recovery Asian Rates Are Not Confirming A Recovery   Chinese onshore interest rates have been a reliable compass for both its business cycle as well as EM share prices and currencies as we illustrated in Chart 15 of the November 28 report. For now, the mainland fixed-income market is not predicting an upturn in China’s industrial economy (Chart I-12, top panel). In Korea, exports account for 40% of GDP. Hence, without a considerable export recovery, there cannot be a business cycle revival in Korea. In brief, the latest relapse in local bond yields could be sending a downbeat signal for global trade (Chart I-12, bottom panel). Third, the four-month rise in the Chinese Caixin manufacturing PMI can be partially explained by front-running production and shipments of smartphones, laptops, computers and other electronics ahead of the December 15 round of US tariffs on imports from China. Right after President Trump announced these tariffs in the summer, businesses likely did not take a chance to wait and see. In fact, whether or not these tariffs would have come into effect was unknown till December 13. Manufacturers and US importers of these electronic goods initiated orders, produced and shipped these goods to the US ahead of December 15. Chart I-13Caixin And Taiwanese PMIs Benefited From Front Running Caixin And Taiwanese PMIs Benefited From Front Running Caixin And Taiwanese PMIs Benefited From Front Running Given the focus on that particular round of tariffs was electronics, producers of these goods got a temporary but notable boost from such front-running. Smartphone and electronics manufacturers and their suppliers are predominantly located in Shenzhen and Taiwan. The Caixin manufacturing PMI is a survey of 500 companies, many of which are private enterprises located in Shenzhen. Not surprisingly, the Caixin manufacturing PMI index often fluctuates with Taiwan’s electronics and optical PMI (Chart I-13). In brief, there has been meaningful improvement in China’s and Taiwan’s tech manufacturing. Yet it can be attributed to front-running of production and shipments of electronic products to the US ahead of the December 15 tariff deadline as well as stockpiling of semiconductors by China. The odds are that these measures of manufacturing will slump in early 2020 as the front-running ends. Chart I-14Commodities Prices In China Commodities Prices In China Commodities Prices In China Finally, several commodities prices in China, that troughed in late 2015 ahead of the bottom in global and EM/Chinese equities in early 2016, continue to drift lower or exhibit only a mild uptick. Specifically, these include prices of nickel, steel, iron ore, thermal coal, coke, polyethylene and rubber (Chart I-14). They corroborate that there has been no broad-based amelioration in the mainland’s industrial sector. Bottom Line: In China, narrow and broad money growth has rolled over, onshore interest rates are subsiding and many commodities prices are weak. All of these signify the lack of sustainable growth revival in China in the coming months.  Putting It All Together EM risk assets have rallied on the consensus market narrative that the temporary truce between the US and China will lift global growth. We have written at length that China’s domestic demand – not its exports – has been the epicenter of and basis for the global slowdown over the past two years. Without Chinese domestic demand and imports, not exports, staging a material amelioration, global trade and manufacturing are unlikely to experience a cyclical upturn.   In short, we doubt that the US-China trade truce is alone sufficient to propel a cyclical recovery in global trade and manufacturing. Yet, when the majority of investors perceive things the same way and act on these perceptions, asset prices can move a lot. We continue to believe that China’s industrial sector, global trade, EM ex-China domestic demand and consequently EM corporate profits will continue to disappoint in the first half of 2020. Nevertheless, we presently concede that we need to give benefit of the doubt to markets. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. It could be that the EM equity and currency market rallies are not driven by their fundamentals – i.e., corporate profits/exports do not matter. However, it is rather possible that this rally is only stoked by the worst-kept secret in the investment industry: the search for yield. If that is the case, then there is no dichotomy between our fundamental thesis – that EM/China profits/growth will disappoint in H1 2020 – and the rally in EM markets. It seems the market is operating on a “buy now, ask questions later” principle. We had thought that the ongoing and enduring contraction in EM corporate profits (please refer to Chart I-11 on page 8) amid various structural malaises would overwhelm the impact of the global search for yield. However, it seems the market is operating on a “buy now, ask questions later” principle. Overall, we are initiating a long position in the EM equity index as of today. Provided the high uncertainty over the outlook, we are also instituting a stop point at 1050 for the MSCI EM equity index, 5% below its current level. For global equity investors, we continue recommending favoring DM over EM stocks. Finally, our country equity overweights are Korea, Thailand, Russia, central Europe, Pakistan, Vietnam and Mexico. A basket of these bourses is likely to outperform the EM equity benchmark in any market scenario in terms of EM absolute share price performance. We have been and remain neutral on Chinese, Indian, Taiwanese and Brazilian equities. As always, our list of overweight, underweight and market weight recommendations for EM equities, local and US dollar government bonds and currencies are available at the end of our report on pages 17-18 and on our website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Ukraine: Buy Local Currency Bonds EM fixed-income investors should buy Ukraine local currency government bonds as well as overweight Ukraine sovereign credit within an EM credit portfolio. The exchange rate is the key for EM fixed-income investors. The Ukrainian hryvnia will be supported by high real interest rates, improving public debt and balance of payment dynamics, as well as abating geopolitical risks. In turn, a stable currency will keep inflation at bay. In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling.  Chart II-1Inflation Will Fall Further Inflation Will Fall Further Inflation Will Fall Further In turn, a stable currency will keep inflation at bay (Chart II-1). In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling. The primary risk of owning Ukrainian domestic bonds is a major depreciation in the hryvnia stemming from a risk-off phase in EM. However, as a periphery country, Ukraine’s financial markets might not correlate with their EM peers. Besides, these bonds offer high carry, which protects them against moderate currency depreciation. Overall, the case for buying Ukraine local currency government bonds is based on the following: First, Ukraine satisfies the two prerequisites for public debt sustainability, namely (1) it runs a robust primary fiscal surplus and/or (2) the government’s borrowing costs are below nominal GDP growth. The public debt-to-GDP ratio stands at 56% and will continue to fall so long as the above two conditions are satisfied. The primary consolidated fiscal surplus currently amounts to 1.8% of GDP (Chart II-2). The recently approved 2020 budget projects the primary surplus to be above 1% of GDP and the overall fiscal deficit to be close to 2% of GDP.  Local currency interest rates are below nominal GDP growth (Chart II-3). In addition, public debt servicing is at 3.2% and 9% as a share of GDP and total government expenditures, respectively. According to the new budget, the government plans to use close to 12% of total spending for debt repayments in 2020. This will further help reduce the public debt load. Chart II-2A Healthy Fiscal Position A Healthy Fiscal Position A Healthy Fiscal Position Chart II-3Interest Rates Are Below Nominal GDP Growth And Are Falling Interest Rates Are Below Nominal GDP Growth And Are Falling Interest Rates Are Below Nominal GDP Growth And Are Falling Second, the central bank has more scope to cut interest rates because various measures of inflation will continue falling. Real (adjusted for inflation) interest rates are still very elevated. In particular, the prime lending rate is at 17% for companies and 35% for households, both in nominal terms. Provided core inflation is running at 6%, lending rates are extremely high in real terms. Not surprisingly, narrow and broad money growth are sluggish (Chart II-4). Commercial banks are undergoing major balance sheet deleveraging: their asset growth is in the low single digits in nominal terms, while their value is dropping relative to nominal GDP (Chart II-5). Chart II-4Money Growth Is Sluggish Money Growth Is Sluggish Money Growth Is Sluggish Chart II-5Deleveraging In The Banking Sector Deleveraging In The Banking Sector Deleveraging In The Banking Sector Meanwhile, tighter regulations are forcing banks to recognize bad assets and boost their capital. This has led to a sharp drop in the number of registered banks. Such a structural overhaul of the banking system is cyclically deflationary and warrants lower interest rates. Critically, these reforms are a positive for the exchange rate in the long run. Third, receding foreign funding pressures are helping the balance of payments dynamics and are supportive for the currency. Ukrainian exports have been outperforming global exports since 2017 (Chart II-6). Agricultural exports – which represent 40% of total exports – are an important source of foreign currency revenue for the country. Chart II-6Ukraine Exports Are Outperforming Global Trade Ukraine Exports Are Outperforming Global Trade Ukraine Exports Are Outperforming Global Trade Chart II-7Tight Fiscal And Monetary Policies Are Good For The Current Account Balance Tight Fiscal And Monetary Policies Are Good For The Current Account Balance Tight Fiscal And Monetary Policies Are Good For The Current Account Balance The current account deficit has been narrowing due to slowing domestic demand, arising from tight fiscal and monetary policies (Chart II-7). Foreign ownership of local currency government bonds is $4.6 billion and it makes only 12% of total outstanding amount. Consequently, risk of major foreign portfolio capital outflows due to a risk-off phase in global markets is low. Lastly, Ukraine’s foreign debt obligations – the sum of short-term claims, interest payment and amortization – have been declining and are presently well covered by exports. They comprise 34% of total exports. Finally, geopolitical risks will continue to subside over the coming months. Peace talks between Ukraine and Russia will continue. Importantly, two sets of constraints could force Ukraine and Russia towards resolving the conflict. Specifically: Russia is constrained by its commitment to be a reliable gas supplier to the EU. Half of its gas export capacity passes through Ukraine. European demand for Russian gas is falling and Gazprom gas revenues are decelerating. Cutting transit of gas through Ukraine could now severely jeopardize Russia’s relations with Europe. Therefore, as much as Europe is dependent on Russian gas, Russia is as dependent on European demand for its natural gas.   The EU’s support for Ukraine is contingent on reliable transits of Russian gas into EU countries. As such, President Zelensky is under pressure from Europe to assure transmission of Russian gas to Europe. This has led Zelensky into opening a dialogue with Russia and motivated him to seek a new gas transit deal with Gazprom. Given President Zelensky’s high popularity at home, he has political capital to pursue a rapprochement with Russia and attempt to find a resolution to end the conflict in the Donbass. All of these developments have been, and will continue to be, positively perceived by international investors, sustaining the recent stampede into Ukraine’s fixed-income markets. Investment Recommendation We recommend investors purchase 5-year local currency government bonds currently yielding 12%. EM fixed-income investors should also consider overweighting US dollar sovereign bonds in an EM credit portfolio on the back of improving public debt and balance of payments dynamics.   Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Mega-theme 1: A hypersensitivity to higher interest rates. Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-theme 2: Europe conquers its disintegration forces. Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-theme 3: Non-China exposed investments outperform structurally. Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega-theme 4: The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Feature Feature ChartUnderweight Materials And Resources In The 2020s Underweight Materials And Resources In The 2020s Underweight Materials And Resources In The 2020s “Study the past if you would divine the future” – Confucius To paraphrase Confucius, we must study the mega-themes of the 2010s if we are to identify the mega-themes of the 2020s. From an economic, financial, and political perspective, the mega-themes of the past decade were: ‘universal QE’; Europe’s threatened disintegration; China becoming the world’s ‘stimulator of last resort’; and the decentralization of information, which threatened the established hierarchies in politics and society. These mega-themes of the 2010s point the way to four mega-themes for the 2020s: A hypersensitivity to higher interest rates. Europe conquers its disintegration forces. Non-China exposed investments outperform structurally. The rise of blockchain and alternative energy. Mega-Theme 1: A Hypersensitivity To Higher Interest Rates The 2010s was the decade of ‘universal QE’. One after another, the world’s major central banks bought trillions of dollars of government bonds (Chart I-2). Yet for all its apparent mystique, QE is nothing more than a signalling mechanism – signalling that central banks intend to keep policy interest rates depressed for a long time. Thereby, QE depresses long-term bond yields – which themselves are nothing more than the expected path of policy interest rates. Chart I-2The 2010s Was The Decade Of 'Universal QE' The 2010s Was The Decade Of 'Universal QE' The 2010s Was The Decade Of 'Universal QE' Something else happens. Close to the lower bound of interest rates, bonds become riskier investments. As holders of Swiss bonds discovered in 2019, low-yielding bonds become a ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. The upshot is that all long-duration assets become risky, and the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds. 'Universal QE' has boosted the valuation of all risky assets. Ten years ago, when the global 10-year bond yielded 3.5 percent, equities offered a prospective 10-year return of 9 percent (per annum). Today, when the bond is yielding around 1.5 percent, equities are offering a paltry 3 percent (Chart I-3 and Chart I-4). Meaning that while the present value of the 10-year bond is up around 20 percent, the present value of equities has surged by 60 percent.1 Chart I-3Equities Are Offering A Paltry 3 Percent Return Equities Are Offering A Paltry 3 Percent Return Equities Are Offering A Paltry 3 Percent Return Chart I-4The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds This exponential dynamic has applied to all risky assets in the 2010s. Most notably, real estate prices have sky-rocketed: Shenzhen 325 percent; Beijing 285 percent; Berlin 125 percent; Bangkok 120 percent; San Francisco 90 percent; Los Angeles 85 percent; Sydney 75 percent; and so on. From 2010 to 2020, the value of global real estate surged from an estimated $160 trillion to $300 trillion.2 The market value of equities also doubled from $35 trillion to $70 trillion.3 But global GDP grew by less than a third from $66 trillion to $85 trillion.3 The upshot is that in 2010 the value of real estate plus equities stood at 2.9 times GDP, whereas in 2020 it stands at 4.5 times GDP. Now add in the aforementioned exponentiality of risk-asset valuations at low bond yields. In 2010, a 1 percent rise in yields required a 10 percent decline in present values, whereas in 2020 it might require a 30 percent decline. In 2010, this meant a decline equivalent to 29 percent of global GDP, but in 2020 it means a decline equivalent to a staggering 135 percent of global GDP.4 So mega-theme 1 for the early 2020s is that any monetary policy tightening – in response to, say, wage inflation fears – will unleash a massive deflationary impulse into the economy from falling stock and real estate prices. This deflationary sledgehammer will annihilate the inflationary peanut, and almost certainly trigger the next major recession. But the good news is that it is unlikely to be a 2020 story, as all the major central banks are in ‘wait-and-see’ mode. Structural recommendation: Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-Theme 2: Europe Conquers Its Disintegration Forces In sub-atomic physics, a nucleus disintegrates when the electrostatic forces pulling it apart becomes stronger than the nuclear forces holding it together. Using the nucleus as a metaphor for Europe, two of the forces pulling it apart have weakened, while one of the forces holding it together has strengthened. We now know that Europe’s biggest rebel – the UK – is leaving the European Union in 2020. In the sub-atomic metaphor, the UK has become a free radical which will try and attach itself to the largest attractive body it can find. But in losing its most wayward member the European nucleus has, by definition, become more cohesive. A second destructive force has been the economic divergences between the ‘core’ and ‘periphery’ European member states. But over the past decade, these divergences have narrowed substantially. Relative to Germany, unit labour costs have declined by 25 percent in Spain, and 15 percent in Italy. More convergence is needed, but the economic forces pulling the European nucleus apart are much weaker in 2020 than they were in 2010 (Chart I-5). Chart I-5The Economic Divergence Between Europe's Core And Periphery Has Narrowed The Economic Divergence Between Europe's Core And Periphery Has Narrowed The Economic Divergence Between Europe's Core And Periphery Has Narrowed Meanwhile, a force holding the European nucleus together has strengthened. In 2010, the Target2 banking imbalance stood at €0.3 trillion; in 2020, it stands close to €1.5 trillion. In simple terms, this means Germany’s exposure to ‘Italian euro’ assets has surged via the ECB’s massive purchases of Italian BTPs. At the same time, Italian investors have parked their cash in German banks, meaning they are owed ‘German euros’ (Chart I-6). Chart I-6Europe’s Target2 Banking Imbalance Stands Close To €1.5 Trillion 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s With such a massive Target2 imbalance, the biggest casualty of the euro’s disintegration would be Germany, whose 2008 recession would look like a stroll in the park. Giving Germany a huge incentive to become more conciliatory to its partners, for example on the use of fiscal stimulus. The best way to play mega-theme 2 is through the currency and bond markets. European equity markets are plays on their dominant sectors, and as we are about to see, many of the sectors over-weighted in Europe face structural headwinds. Structural recommendation: Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-Theme 3: Non-China Exposed Investments Outperform Structurally The 2010s was the decade when China became the global ‘stimulator of last resort’. Prior to the 2010s, the credit impulse in China was inconsequential compared to the credit impulses in the US and Europe. But in the 2010s the tables turned. The credit impulses in the US and Europe became inconsequential, as the amplitude of China’s waves of stimulus swamped all others (Chart I-7). Chart I-7In The 2010s, China Became The Global 'Stimulator Of Last Resort' In The 2010s, China Became The Global 'Stimulator Of Last Resort' In The 2010s, China Became The Global 'Stimulator Of Last Resort' China became the global stimulator of last resort because in 2010 its indebtedness was significantly less than in other major economies. But today, China’s indebtedness has overtaken the others, and is levelling off at a point that has proved to be a reliable upper bound (Chart I-8). Chart I-8China's Indebtedness Is Reaching Its Upper Bound China's Indebtedness Is Reaching Its Upper Bound China's Indebtedness Is Reaching Its Upper Bound An upper bound to indebtedness exists because further debt creates mal-investments whose returns are lower than the cost of the debt. And as indebtedness approaches the upper bound, each wave of stimulus loses potency compared to the preceding wave. For example, in 2011 China’s nominal GDP growth accelerated to 20 percent, but in 2017 it accelerated to 10 percent. In the financial markets, China’s waves of stimulus enabled short bursts of countertrend outperformance within the structural bear market in materials and resources – sectors which feature large in European markets. However, as Chinese stimulus loses its potency in the 2020, the structural bear markets in China-exposed investments will re-establish (Chart I-1). Structural recommendation: Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega Theme 4: The Rise Of Blockchain And Alternative Energy Historian Niall Ferguson describes history as a perpetual oscillation between periods dominated by centralized hierarchies and periods dominated by decentralized networks. And quite often, he says, the switch is enabled by a revolutionary new technology. For example, the advent of the printing press in the mid-15th century catalysed the Protestant Reformation and turbocharged the Renaissance by unleashing a decentralization of knowledge, information, and news. Sound familiar? In the early-21st century the internet has similarly decentralized the production and consumption of knowledge, information, and news. And the new networked age has threatened the established hierarchies in politics and society, fuelled populism, and disrupted many sectors in the economy. Yet Ferguson points out that it is futile (as well as Luddite) to resist such shifts from hierarchical structures towards decentralized networks. In the 2020s the decentralization baton will pass from the internet to the blockchain. Just as the internet decentralizes information, the blockchain decentralizes intermediation and trust functions. Hence, the blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law. The blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law.  By the end of the decade, you will no longer need a bank to intermediate your excess savings to a borrower. And you will no longer need a lawyer to oversee a change of ownership. The blockchain will do these for you just as securely and much more cost effectively. One consequence is that the nature of the world’s energy requirements will change. The blockchain is very energy intensive, but unlike the internal combustion engine, the energy does not have to be portable. Hence, there will be a structural shift towards energy in the form of ‘moving electrons’ and away from energy in the form of the ‘chemical bonds’ in fossil fuels. This will be a boon for the alternative energy sector at the expense of oil and gas (Chart I-9). Chart I-9Underweight Oil And Gas In The 2020s Underweight Oil And Gas In The 2020s Underweight Oil And Gas In The 2020s We will cover this mega-theme in more detail in a Special Report next year. Structural recommendation: Overweight alternative energy, underweight oil and gas, underweight financials. And with that, it’s time to sign off for this year and for this decade. I do hope that you have found the past decade’s reports insightful, sometimes provocative, but always enjoyable. We promise to continue in the same vein in the 2020s. It just remains for me and the team to wish you a happy new year and a happy new decade! Fractal Trading System* The Conservatives won a surprise landslide victory in the UK election last week, but fractal structures suggest that some of the market euphoria is now overdone. Specifically, the 30 percent rally in UK homebuilders through the last 65 days is vulnerable to a short-term countertrend move. Accordingly, this week’s recommended trade is short UK homebuilders / long UK oil and gas. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-10UK: Homebuilders Vs. Oil and Gas UK: Homebuilders Vs. Oil and Gas UK: Homebuilders Vs. Oil and Gas In other trades, short MSCI AC World versus the global 10-year bond was closed at its 2.5 percent stop-loss, leaving three trades in comfortable profit, one neutral, and one in loss. 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 Footnotes 1 In simple terms, if the 10-year yield declines by 2 percent, a 2 percent a year lower return for 10 years requires the present value to rise by 2 percent times 10, which equals 20 percent. In the case of equities, the equivalent calculation is 6 percent times 10, which equals 60 percent. 2 Source: Savills 3 Source: Thomson Reuters 4 2.9 times 10 percent equals 29 percent, 4.5 times 30 percent equals 135 percent. Fractal Trading System 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s   Cyclical Recommendations Structural Recommendations 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity

Highlights OPEC 2.0 production discipline and the capital markets’ parsimony in re funding US shale-oil producers will restrain oil supply growth. Monetary and fiscal stimulus will revive EM demand. These fundamentals will push inventories lower, further backwardating forward curves. Base metals demand will pick up as EM income growth revives. Demand also will get a boost from the ceasefire in the Sino-US trade war. Gold will remain range-bound for most of next year: A weaker USD and rising inflation expectations are bullish, but rising bond yields and reduced trade tensions will be headwinds. Grain markets will drift, although dry conditions in Argentina and the trade-war ceasefire could provide short-term price support, along with a weaker USD. Risk to our view: Continued elevated global policy uncertainty would support a stronger USD and stymie central bank efforts to revive global growth in 2020. Feature Dear Client, We present our key views for 2020 in this issue of Commodity & Energy Strategy. This will be our last publication of 2019, and we would like to take the opportunity to thank you for your on-going interest in the commodity markets and in our publication. It has been our privilege to serve you. We wish you and your loved ones all the best of this beautiful Christmas season and a prosperous New Year in 2020! Robert Ryan Chief Commodity & Energy Strategist Going into 2020, policy uncertainty again will be a key driver of commodity demand, the Sino-US trade-war ceasefire and UK election results notwithstanding.1 As uncertainty has increased, demand for safe havens like the USD and gold have increased. The principal impact of this uncertainty shows up in FX markets. As uncertainty has increased, demand for safe havens like the USD and gold has increased. Indeed, the Fed’s Broad Trade-Weighted USD index for goods (TWIBG) has become highly correlated with the Global Economic Policy Uncertainty index (GEPU). The three-year rolling correlation between these indexes reached a record high in November 2019 (Chart of the Week).2 Individually, the record for the TWIBG was posted in September 2019, while the GEPU record was hit in August 2019. Chart of the WeekGlobal Economic Policy Uncertainty Highly Correlated With USD 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets A strong USD affects commodity demand directly, because it slows income growth in EM economies – the engine-house of commodity demand. A stronger USD raises the local-currency cost of consuming commodities – an important driver of EM demand – and reduces the local-currency cost of producing commodities. So, at the margin, demand is pressured lower and supply growth is incentivized – together, these effects combine to push prices lower. Economic policy uncertainty likely will diminish in early 2020, following the Sino-US trade-war ceasefire, the decisive UK election results and continued central-bank signaling – particularly from the Fed – that rates policy will remain accommodative for the foreseeable future. That said, the ceasefire does not mark the end of the Sino-US trade war, and many issues – ongoing US-China tensions, US election uncertainty, global populism and nationalism, rising geopolitical tensions in the Persian Gulf, ad hoc monetary policy globally – still are to be resolved. Terra Incognita The GEPU index does not measure uncertainty per se, as uncertainty per se cannot be measured.3 The index picks up word usage connected with the word “uncertainty.” So, it is more the perception of uncertainty that is being reported by Economic Policy Uncertainty in its data. Nonetheless, this is a good way to measure such sentiment, as research from the St. Louis Fed found: “Increases in the economic uncertainty index tend to be associated with declines (or slower growth) in real GDP and in real business fixed investment.” In past three years, increased policy uncertainty also has been fueling demand for safe havens, chiefly the USD and gold. This is a highly unusual coincidence – i.e., a rising USD accompanied by a rising gold price. Typically, a weaker USD puts a bid under gold prices. Indeed, this relationship is one of the primary drivers of our gold model, which suggests the effect of the heightened policy uncertainty dominates the USD impact on gold prices in the current environment (Chart 2). Chart 2Gold Typically Rallies When the USD Weakens Gold Typically Rallies When the USD Weakens Gold Typically Rallies When the USD Weakens The flip-side of the deleterious effects of higher economic policy uncertainty is its resolution: Growing cash balances and a higher capacity to lever balance sheets of households, firms and investor accounts means there is a lot of dry powder available to recharge growth in the real and financial economies globally.4 Chart 3BCA's Grwowth Gauges Indicate Global Economy Rebounding BCA's Grwowth Gauges Indicate Global Economy Rebounding BCA's Grwowth Gauges Indicate Global Economy Rebounding Our commodity-driven economic activity gauges are picking up growth impulses, most likely in response to the global monetary stimulus that has been deployed this year (Chart 3). In addition, systemically important central banks have given no indication they are going to be reversing this stimulus. A meaningful reduction in uncertainty could turbo-charge global growth prospects. Below, we provide our key views for each of the commodity complexes we cover. Oil Outlook Energy: Overweight. The oil market is poised to move higher on the back of OPEC 2.0’s deepening of production cuts to 1.7mm b/d, mostly because of actions by the Kingdom of Saudi Arabia (KSA) to cut output deeper, to a total of close to 900k b/d vs. its October 2018 production levels.5 Combined with the loss of ~ 1.9mm b/d of production in Iran and Venezuela due to US sanctions, the supply side can be expected to tighten next year (Chart 4). The Vienna meeting – which ended December 6, 2019 – demonstrated commitment to OPEC 2.0’s production-restraint strategy, and we expect member states will deliver. At least they will reduce the incidence of free riding at KSA’s expense – there were subtle hints from the Saudis they will not tolerate such behavior. KSA’s threats in this regard are credible, given its follow-through in 1986 when they surged production and briefly drove WTI prices below $10/bbl to send a message to free riders in the OPEC cartel. The Saudis acted similarly during the 2014 – 2016 market share war. US shale-oil production growth will slow next year to 800k b/d y/y, vs. the 1.35mm b/d we expect for this year. US lower 48 crude production will increase to 10.7mm b/d in 2020, taking total US production to 13.1mm b/d, a ~ 850k b/d increase y/y. On the demand side, we lowered our expectation for 2019 growth to 1.0mm b/d, given the continued downgrades of historical consumption estimates this year from the EIA, IEA and OPEC. Nonetheless, we continue to expect 2020 growth of 1.4mm b/d, on the back of continued easing of global financial conditions, led by central-bank accommodation. Given our view, we remain long oil exposures in several ways. First, we remain long WTI futures outright going into 2020; this position is up 30% from January 3, 2019 when it was initiated. Second, we recommended getting long 2H20 vs. short 2H21 Brent futures, expecting crude oil forward curves to backwardate further as tighter supply and stronger demand force refiners to draw inventories harder next year (Chart 5). Chart 4Markets Will Tighten In 2020 Markets Will Tighten In 2020 Markets Will Tighten In 2020 Chart 5Oil Inventories Will Draw Harder In 2020 Oil Inventories Will Draw Harder In 2020 Oil Inventories Will Draw Harder In 2020 We expect Brent crude oil to average $67/bbl next year, given the fundamentals outlined above. We also expect a weaker dollar to be supportive of demand ex-US. WTI will trade at a $4/bbl discount to Brent next year, based on our modeling (Chart 6). Chart 6Brent, WTI Will Trade Higher Brent, WTI Will Trade Higher Brent, WTI Will Trade Higher We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. Bottom Line: We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. This expectation will be challenged by continued economic policy uncertainty. On the flip side, however, a meaningful resolution to this uncertainty could turbo-charge growth as real economic activity picks up and the USD weakens. Base Metals Outlook Base Metals: Neutral. We remain strategically neutral base metals going into 2020, but tactically bullish, carrying a long LMEX and iron-ore spread position into the new year.6 The behavior of base metals prices – used by economists as proxies for EM growth – is indicating industrial demand is picking up (Chart 7). This aligns well with our proprietary indicators of commodity demand and global industrial activity (Chart 8). Base metals prices are more sensitive to changes in global growth than other commodities. For this reason, we use these prices to confirm the signals coming from the proprietary models we use to gauge EM growth. Chart 7Base Metals Prices Signaling EM Growth Revival Base Metals Prices Signaling EM Growth Revival Base Metals Prices Signaling EM Growth Revival The so-called phase-one agreement to reduce tariffs in the Sino-US trade war will support global demand at the margin for base metals. This is a ceasefire in the trade war not a resolution, so we are not expecting a surge in demand. Chart 8BCA Proprietary Indicators Also Signaling Growth Revival BCA Proprietary Indicators Also Signaling Growth Revival BCA Proprietary Indicators Also Signaling Growth Revival That said, base metals – aluminum and copper, in particular – have a tailwind in the form of global monetary accommodation by central banks. This was undertaken to reverse the negative effect on global financial conditions brought about by the Fed’s rates normalization policy last year and China’s 2017-18 deleveraging campaign. In addition, our China strategists expect modest fiscal and monetary stimulus from Beijing, which also will be supportive of demand.7 Aluminium and copper comprise 75% of the LMEX index. These are primary industrial markets, in which China accounts for ~ 50% of global demand, and EM ex-China demand remains stout. Even with a trade war raging for most of 2019, the supply and demand of aluminum and copper – the largest components of the LMEX index – was diverging: Consumption outpaced production – a multi-year trend – which forced inventories to draw hard (Charts 9A and 9B). Chart 9AGlobal Aluminum Markets Getting Tighter … Global Aluminum Markets Getting Tighter ... Global Aluminum Markets Getting Tighter ... Chart 9B… As Are Copper Markets ... As Are Copper Markets ... As Are Copper Markets Bottom Line: Inventories in industrial-metals markets have been drawing hard for years – particularly in aluminum – as metals' demand remained above supply. Given this, we are long the LMEX index: Even a marginal growth pick-up could rally prices. Precious Metals Outlook Precious Metals: Neutral. Going into 2020, gold’s outlook could be volatile – especially in 1H20 – as the metal’s key drivers will send conflicting signals (Table 1). Table 1Fundamental And Technical Gold-Price Drivers 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets Gold prices are holding up above $1,450/oz. Our latest fair-value estimate indicates gold will hover around $1,475/Oz over the short-term (Chart 10). We break next year’s gold forecast into two parts: Phase 1: Growth revival and uncertainty respite. These two factors are closely intertwined; the magnitude of global growth’s rebound is conditional on a reduction of global economic policy uncertainty. We expect this relief will come from a ceasefire in the US-China trade war. Combined, accelerating economic activity – mainly driven by EM economies – and falling uncertainty will push the US dollar lower.8 For gold prices, this phase will be characterized by two contrasting forces: A falling USD (bullish gold) vs. lower safe-haven demand and rising US interest rates (bearish gold). US rates will increase early next year as global uncertainty is reduced and bond markets price-out Fed rates cuts. The current unusually high correlation between gold and US rates implies gold will face selling pressures during this period (Chart 11). Nonetheless, we expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Chart 10High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 Chart 11US Rates Could Hurt Gold Prices In 1H20 US Rates Could Hurt Gold Prices In 1H20 US Rates Could Hurt Gold Prices In 1H20 Phase 2: EM wealth effect and inflation rebound. As income growth accelerates, EM households will slowly accumulate jewelry, coins, and bars – of which China and India are the largest consumers. Demand pressure from these consumers will manifest itself in 2H20, adding to buoyant central-banks purchases of gold. The upside in bond yields will be limited by major central banks’ dovish stance until inflation is well-established above target. Closely monitoring the evolution of inflation will become increasingly important in 2020, given inflation pressures are building in the US and globally (Chart 12). A lower USD – supporting stronger commodity demand – will magnify global inflation trends (Chart 13). There is a very real risk inflation shoots up in 4Q20, keeping real rates low. This differs from our BCA House view, which does not see inflation pressures building until 2021. Chart 12Inflationary Pressures Are Building Up In The US And Globally Inflationary Pressures Are Building Up In The US And Globally Inflationary Pressures Are Building Up In The US And Globally Political uncertainty likely will return ahead of the 2020 US election. A resurgence in popular support for one of the progressive Democratic candidates – Elizabeth Warren or Bernie Sanders – could disrupt US stock markets. Gold would advance in such an environment. Chart 13No Inflation Without A Weaker USD No Inflation Without A Weaker USD No Inflation Without A Weaker USD Progressive populists would lead to domestic policy uncertainty and larger budget deficits, yet would not remove the threat of trade protectionism. We expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Bottom Line: Gold prices will move sideways in 1H20 and will drift higher in 4Q20 supported by depressed real rates, a lower dollar, and US election uncertainty. Silver Market Chart 14Silver Prices Will Move Higher With Gold Prices Silver Prices Will Move Higher With Gold Prices Silver Prices Will Move Higher With Gold Prices Silver prices have traded closely with gold since the Global Financial Crisis (GFC), moreso than with industrial metals (Chart 14). Prior to the GFC, silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization. Post-GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. Thus, we expect it will continue to follow the evolution of gold prices outlined above. Nonetheless, industrial applications still represent ~ 50% of silver’s physical demand and its supply-demand balance is estimated to have been tight this year. Silver likely will outperform gold next year as global growth and industrial activity rebound. PGM Markets The palladium market will remain tight in 2020. According to Johnson Matthey, the 10-year-long supply deficit is expected to widen massively this year, when all’s said and done. Prices surpassed $1,900/oz in December, forcing inventory liquidation (Chart 15). We believe the platinum-to-palladium ratio is at a level that would incentivize substitution in the pollution-control technology in gasoline-powered engines, and supports higher platinum content in diesel catalyzers (Chart 16).9 Nonetheless, swapping palladium for platinum is complex and requires a redesign of the production process. A lot will depend on how much the added cost of the more expensive palladium affects new-car buyers’ demand.10 To date, there are no signs car makers have already – or are willing to – initiate this process on a significant scale. Chart 15Palladium Inventories Are Depleted Palladium Inventories Are Depleted Palladium Inventories Are Depleted A few factors need to align to incentivize substitution of palladium for platinum. The price ratio between the two metals should reach extreme levels; the price divergence should be expected to last for a prolonged period of time, and concerns over supply security of platinum should be low. Chart 16Relative Inventory levels Drive The Palladium To Platinum Price Ratio Relative Inventory levels Drive The Palladium To Platinum Price Ratio Relative Inventory levels Drive The Palladium To Platinum Price Ratio In today’s context, this last condition could slow substitution. South African platinum supply – which represents close to 73% of the world primary supply – is projected to fall by close to 3% next year. Automakers need stable platinum supplies as they increase their demand for the metal and with persistent power-supply issues in South Africa – exacerbated by recent flooding – this condition will be hard to meet. No market has been harder hit by the Sino-US trade war than grains and ags generally. Thus, palladium holds an advantage over platinum on that front. Its supply sources are more diversified, and with 15% comes from stable North American countries and 40% comes from Russia. We believe substitution will commence, but this is a gradual process and will only slowly affect the metals’ price ratio.11 For 2020, we expect palladium prices to continue increasing due to stricter pollution regulation in China, India, and Europe.12 Ag Outlook Chart 17Sino-US Trade War, USD Hammer Grain Prices Sino-US Trade War, USD Hammer Grain Prices Sino-US Trade War, USD Hammer Grain Prices Ags/Softs: Underweight. The final form of the ceasefire in the Sino-US trade war – i.e., the “phase one” deal between China and the US to roll back tariffs – has yet to show itself. Last Friday, US Trade Representative Robert Lighthizer stated China has agreed to buy $32 billion – over the next two years – of US ag products as part of a “phase one” deal. This news moved corn, wheat and beans prices up 6.3%, 3.2%, and 3.4% respectively as of Tuesday’s close. Another positive news for US farmers was an announcement from the USDA that the final $3.6 billion of the $14.5 billion budgeted for farm subsidies this year to offset the trade war impact on US farmers most likely would be made in the near future by the Trump administration.13 No market has been harder hit by the Sino-US trade war than grains and ags generally. Severe weather across much of the US Midwest should have produced a rally, as offshore demand competed for available supply, which likely would have been lower at the margin last year absent a trade war. Instead, corn, wheat and beans are going into 2020 pretty much at the same price levels they went into 2019. In addition to the deleterious effect of the US-China trade war, ag markets have been particularly hard hit by the strong USD, which makes exports from the US expensive relative to alternative suppliers – e.g., Argentina and Brazil, which are posing serious challenges to US farmers (Chart 17).   Global inventories are, nonetheless, being whittled away, which is good news for farmers generally (Chart 18). And, this likely will continue in 2020, given the physical deficits expected this year (Chart 19). Chart 18GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... Chart 19... Physical Deficits Will Whittle Stocks Further Next Year ... Physical Deficits Will Whittle Stocks Further Next Year ... Physical Deficits Will Whittle Stocks Further Next Year Markets are still awaiting final details of the ceasefire in the Sino-US trade war. The deal is expected to be signed in the first week of January. 2020 could be the year the global ag markets come more into balance, with stocks-to-use levels falling and normal trade resuming. We are not inclined to take a view on this possibility and are therefore remaining underweight the ag complex. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Our outlook last year was entitled 2019 Key Views: Policy-Induced Volatility Will Drive Markets. It was published December 13, 2018, and is available at ces.bcaresearch.com. This year’s outlook again reflects our House view, which was published in the Bank Credit Analyst on November 28, 2019, entitled OUTLOOK 2020: Heading Into The End Game. It was sent to all clients last month and is available at bca.bcaresearch.com. 2 Uncertainty is measured using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange rates-weighted basis) are scoured monthly to create the index. Please see Economic Policy Uncertainty for additional information. We use the Fed's USD broad trade-weighted index for goods (TWIBG) reported by the St. Louis Fed to track the USD. Please see the St. Louis Fed’s FRED website at Trade Weighted U.S. Dollar Index: Broad, Goods. 3In a June 2011 interview with the Minneapolis Fed, Ricardo Caballero, a professor of economics at MIT, provided a succinct description of risk and uncertainty, paraphrasing former US Defense Secretary under President George W. Bush Donald Rumsfeld: “(W)hen he talked about the difference between known unknowns and unknown unknowns. The former is risk; the latter is uncertainty. Risk has a more or less well-defined set of outcomes and probabilities associated with them. Uncertainty does not—things are much less clear.” Kevin L. Kliesen of the St. Louis Fed explores the link between rising uncertainty and slower economic growth in Uncertainty and the Economy (April 2013), observing, “If the business and financial community believes the near-term outlook is murkier than usual, then the pace of hiring and outlays for capital spending projects may be unnecessarily constrained, thereby slowing the overall pace of economic activity.” 4The Wall Street Journal reported investors have accumulated a $3.4 trillion cash position, a decade-high level; this is consistent with the risk aversion that can be expected when economic uncertainty is high. Please see Ready to Boost Stocks: Investors’ Multitrillion Cash Hoard, published by The Wall Street Journal November 5, 2019. 5 Accounting for Saudi Arabia's 400k b/d of additional voluntary cuts. 6 The LMEX no long trades on the LME, but we are using the index as a proxy for a position. In iron ore, we are long December 2020 65% Fe futures vs. short 62% Fe futures on the Singapore Exchange, expecting steelmakers will favor the high-grade material in the new mills they’ve brought on line. 7 Our China strategists expect “Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate.” Please see 2020 Key Views: Four Themes For China In The Coming Year, published by BCA Research’s China Investment Strategy December 11, 2019. It is available at cis.bcareserach.com. 8 The US dollar is a countercyclical – i.e. it is inversely correlated with the global business cycle – due to the fact that the US economy is driven more by services than manufacturing. 9 Palladium is used mostly in pollution-abatement catalysts in gasoline-powered cars, while Platinum is favored in diesel-engine cars (along with a small amount of palladium). Catalysts production represents close to 80% and 45% of palladium's and platinum's total demand. 10 Considering there’s ~ 3.5g of palladium in a new car and palladium trades at ~ $1,900/oz, close to $240 is added to the cost of a new gasoline-powered car by using this metal in pollution-abatement technology. 11 Please see South African Mines Grind To Halt As Floods Deepen Power Crisis, published by reuters.com on December 10, 2019. 12 Stricter emissions standards in the car industry – mainly in China where China 6 emissions legislation is taking effect – are increasing the PGMs loadings in each car, supporting demand growth. 13 Please see China May Agree to Buy U.S. Ag Exports, But a Final Tranche of Cash to Farmers is Still Likely, published by agriculture.com’s Successful Farming news service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets