Policy

Dear Client, Owing to BCA’s 40th Annual Investment Conference at the Grand Hyatt in New York City next week, there will be no report on Wednesday, September 25. We will return to our regular publication schedule on Wednesday, October 2. I look forward to meeting China Investment Strategy clients in person at our conference. Please do not hesitate to say hello. Best regards, Jing Sima China Strategist Highlights China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in the coming few months if the economy slows further, but policymakers will be reactive rather than proactive. Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy. Over a 6-12 month time horizon, investors should continue to overweight Chinese stocks versus the global benchmark in currency hedged terms, but the risk of further underperformance over the near-term is high. Feature Chinese economic growth continues to weaken. The Caixin manufacturing PMI for August, along with the New Export Orders component of the manufacturing PMI released by China’s National Bureau of Statistics, registered small gains in August from July. However, any hopes pinned on this being an emerging sign of turnaround in the Chinese economy soon faded. A slew of August data showed continued sluggishness in exports, an even worse domestic-demand picture, and further deflation in ex-factory producer prices. Most importantly, we continue to witness “half-measured” stimulus. In explaining past and existing economic weakness, many investors point to the trade war with the U.S. However, Charts 1 and 2 serve as an important reminder that domestic weakness predates U.S. protectionism. The trade war tensions and tariffs are magnifying this weakness, but China’s slowdown is, at its core, policy driven. Chart 1Weakness In Chinese Economy Predates The Trade War... Chart 2…And Has Been A Byproduct Of Financial De-Risking Campaign Given this, investors should be more focused on identifying signs of a major reversal in policy. So far Chinese policymakers have been firmly holding their line in keeping credit growth somewhat in check.  Policy-Induced Economic Stabilization: A Tough Forecast To Make Our baseline view is that the current scale of stimulus should be sufficient to stop economic growth from decelerating further.  Two factors support our baseline view: The direct impact from tariffs on the Chinese economy is limited. Growth in China’s exports to the U.S. in 2019 is likely to be somewhere close to a 9% contraction, down from the 10.8% increase registered in 2018. Based on a simple calculation with all else being equal, this is likely to shave 1.6 percentage points off China’s total export growth and 0.3 percentage points off nominal GDP growth in 2019. This is not trivial, but arguably not devastating to China’s aggregate economy either. There is anecdotal evidence suggesting some Chinese exports have been re-routed to peripheral countries such as Vietnam and Taiwan in order to avoid the U.S. import tariffs on Chinese goods (Chart 3). This suggests that real growth in Chinese exports to the U.S. could be stronger than the current data suggests. Chart 3Exports Finding Alternative Routes? Chart 4Bottoming in the economy In Sight? Credit growth has picked up since the beginning of this year. Based on the historical relationship between China’s credit impulse (measured by the 12-month change in BCA’s adjusted total social financing as a percentage of nominal GDP) and domestic demand, the economy should bottom out at some point before the end of the year (Chart 4). Although, import growth, a key measure of China’s domestic demand, remains in deep contraction, some of its components that usually lead industrial activities are showing signs of improvement (Chart 5). Chart 5Early Signs of Improved Domestic Demand Chart 6Manufacturing Investment Growth In Contraction However, our level of confidence that the existing stimulus will be sufficient to stabilize economic growth is lower than it otherwise would be. This is due to the fact that the challenges facing the Chinese economy are unprecedented in nature.  For one, the indirect impact of the trade war on China’s economy through business sentiment and manufacturing investment has yet to be fully revealed in the data. As Chart 6 shows, manufacturing investment is already deteriorating, particularly in export-intensive sectors. The ultimate impact on investment from the trade war is still uncertain, and can pose significant downside risks to the Chinese economy in the coming year. More importantly, as Chart 7 suggests, a weak credit impulse will at best lead to a very subdued economic recovery even if growth does indeed bottom. In terms of the link between policy and the economy, Chart 8 points out a key difference between the current slowdown and previous down cycles: Monetary conditions have been ultra-loose for more than a year, but current economic conditions remain on a downward trend – much more so than in the previous cycles. This huge gap and lag in economic response to monetary stance can only be explained by an impaired policy transmission mechanism. An expansionary monetary stance has not proportionally translated into credit expansion or economic recovery. This challenges the effectiveness and timeliness of future monetary loosening in terms of its ability to revive the Chinese economy. Chart 7Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Chart 8An Impaired Monetary Policy Transmission The scale and timing of the current stimulus measures have been “behind the curve.” Therefore, the historical relationship between China’s credit impulse and the turning points in the economy may not apply to the current cycle. Bottom Line: China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. An Unusually Prudent Policy Bias For some, the recent slew of announcements on upcoming stimulus qualified as a major shift in policy bias. Our analysis suggests otherwise. The bank reserve requirement ratio (RRR) cuts announced late in August have been among the most cited policy announcements, with the PBoC stating that the new cuts will release RMB 900 billion of fresh liquidity.1 In our view, this measure is more about maintaining liquidity in China’s large commercial banks than adding to it (on a net basis). Chart 9RRR Cuts May Not Be That Stimulative Chart 9 shows that, in previous episodes of meaningful RMB depreciation against the U.S. dollar, in order to prevent the RMB from falling at an undesirable pace, PBoC has had to intervene in the spot market by selling U.S. dollars. The selling of U.S. dollars in this round of RMB depreciation has been much more muted than in 2015-2016, but we suspect some intervention has taken place following each bout of escalation in the trade war. This has had a liquidity tightening effect on banks, as selling central bank foreign-exchange reserves reduces liquidity in the banking system. It is very likely that following the PBoC’s defense of the RMB in the last two months, the RRR cuts were a measure aimed at preventing a liquidity crunch ahead of the September tax season. If true, this hardly qualifies as net new stimulus for the economy. There were also two important announcements that came out of the September 5th State Council meeting: The entire 2019 quota for local government special project bonds must be issued by the end of September, and all money raised from the bonds must be disbursed to projects by the end of October. This too is not exactly “stimulative,” as over 90% of the 2019 local government special-project bond quota has already been issued. This leaves less than 10% of the quota outstanding, an 80% decline from what was issued last September. On a quarterly basis, special-bond issuance in the third quarter of 2019 will end up being 30% lower than the same period last year.   It was also announced that, in order to meet the local needs for construction of key projects, part of 2020’s special bonds quota will be allocated in advance to ensure that the funds are available for use at the beginning of next year.2  While the announcement did not indicate how much in the way of special-purpose bonds local governments are allowed to frontload through the remainder of this year, we maintain our view that this is not a policy shift towards materially larger stimulus than we have seen so far this year: Without an additional quota, local government special-purpose bond issuance would essentially fall to zero in the fourth quarter as the 2019 target would be hit by the end of September. Thus, the frontloading of next year’s bond issuance will only “fill the gap” between now and year-end. As special-purpose bond issuance only accounts for 15% of total funding for local governments’ infrastructure spending, the new measure alone is unlikely to meaningfully accelerate investment growth.3  We have noted in previous reports that in order for local governments to accelerate spending within the current fiscal budget framework, one of three things must occur: more direct funding from the central government, an acceptance by policymakers of more shadow bank lending, or a larger quota for bond issuance. So far we have not seen any of the above-mentioned shifts in policy. Chart 10Local Governments Tightening Belt This Year The only positive sign for local government spending has been a pickup in land sales in Q2, which makes up more than 70% of local government revenues. But, it is far from making up the shortfalls in local governments’ budgets (Chart 10). Local governments are facing considerable fiscal pressure as annual tax revenue growth has fallen to near zero. Critically, the government’s regulatory stance on local government budgets has continued to tighten: Local governments have been ordered by the Ministry of Finance to liquidate state-owned assets to fund their budget deficits this year.4 This austerity measure is also being met with explicit reiteration from the Ministry of Finance on the central government not bailing out local governments, and that local government officials are held responsible for their own borrowing and spending.5   Bottom Line: Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in early 2020 if the economy slows further in Q4, but policymakers will most likely continue their reactive approach rather than proactive. RMB Depreciation: A Plus Or Peril? The RMB’s renewed depreciation since August initially raised fears among global investors that an uncontrolled decline might occur, but these fears have subsided over the past several weeks. Even though the USD-CNY exchange rate has broken the psychological 7 threshold, it is not forming a linear downward trend. Unlike after the August 2015 devaluation, it appears that the PBoC can successfully enact countercyclical measures to guide the RMB’s value higher following each large depreciation (Chart 11). Chart 11PBoC Not Panicking Over RMB Depreciation Fears of uncontrolled capital outflows following the depreciation are also abating. We presented a dashboard for monitoring short-term capital outflows from China in our March 20 Special Report,6 and an update of these indicators suggests that China’s heightened capital controls are holding – i.e., outflows have not escalated as they did in 2015 (Chart 12). Chart 12No Major Capital Outflow Chart 13RMB Depreciation Partially Offsets Tariffs Thus, the conclusion is that Chinese policymakers appear to be in control of the currency. The reduced risk of an uncontrolled decline has allowed policymakers to (passively) provide meaningful stimulus to the domestic economy via depreciation. Indeed, the RMB has not only depreciated against the USD, but also against many Asian currencies including direct trade competitors such as Vietnam and Taiwan (Chart 13). This is helping offset the negative impact of U.S. tariffs on Chinese exporters. But currency devaluation can come with a price tag – in particular for corporations that have borrowed heavily in U.S. dollar-denominated debt. We estimate that $440 billion of U.S. dollar debt will be maturing over the coming two years, for Chinese companies and banks in the aggregate.7 A 12% depreciation in the RMB since April 2018 means that debt servicing costs will be 12% higher for unhedged debtors. This is particularly painful for real estate and financial services companies, two of the largest holders of U.S. dollar-denominated loans, and the weakest sectors in the current economic downturn. Most importantly, while currency devaluation ease the slowdown, it cannot be counted on to stabilize Chinese economic activity on its own. For example, while our earnings recession model suggests that the decline in the RMB since May has reduced the odds of a major decline in economic activity by roughly 20%, the model also shows that such an event is still highly probable (current odds are roughly at 70%). Bottom Line: Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy if a further slowdown occurs. An Update On Corporate Earnings Against a backdrop of what may turn out to be insufficient policy support, the earnings picture is providing one modest positive for equity investors. While the growth rate in investable earnings per share has slowed significantly over the past year (Chart 14), it has merely fallen to zero and not deeply into negative territory, as what seemingly occurred in 2015-2016. In our view, the risk of a similar collapse in earnings per share (EPS) has been an important factor weighing on Chinese investable equities’ relative performance since June 2018. In reality, a closer examination of MSCI China Index earnings reveals that a huge decline in EPS this year was never really a threat, because the apparent collapse in 2015-2016 did not actually transpire. Changes to the composition in the MSCI China Index that took effect in November 2015 and June 2016 had the effect of depressing index EPS, due to the sizeable inclusion of a set of richly valued stocks. Chart 15 presents BCA’s calculation of “break-adjusted” EPS for Chinese investable stocks, which shows that EPS growth bottomed out at -10% in late-2016, as opposed to the -28% implied by the unadjusted series. Chart 14Investable EPS Has Yet To Contract Meaningfully Chart 15The Potential Downside For Earnings Is Less Than Many Fear Chart 16A Cyclical Recovery In Earnings Has Not Yet Begun The existence of less downside potential for earnings is certainly positive for investable stocks at the margin, but it does not alter the outlook for equity fundamentals over the coming year. We have shown in several previous reports that there is a strong and reliable link between investable EPS growth and China’s coincident economic activity,8 and the continued slowing in the latter does not suggest that a bottom in earnings is imminent. In addition, Chart 16 highlights that while net earnings revisions have recovered from their early-year lows, they remain in negative territory and have stopped rising over the past few weeks. Twelve-month forward EPS momentum, also presented on a break-adjusted basis, is modestly negative, and has recently weakened (panel 2). Bottom Line: The downside risk to earnings for Chinese investable equities is less than many investors fear. But absent stronger credit growth, it remains too early to confidently project a cyclical earnings recovery. Investment Conclusions The historical relationship between credit growth and economic activity suggests that the latter should soon stabilize, which is our base case view for the coming few months. Still, the risk of a further, meaningful deceleration in growth is elevated, given the unprecedented circumstances surrounding the ongoing slowdown. For equity investors, less potential downside risks to earnings than previously feared is a positive at the margin, but the fundamental outlook still hinges on a durable pickup in economic activity. Over a 6-12 month time horizon, this implies that one of two scenarios will unfold: The economy will stabilize in response to the easing that has already occurred (i.e. our base case view). The economy slows further in the near-term, prompting a more significant policy response that leads to an even sharper pickup in activity. Chart 17Investable Stocks: An Overshoot To The Downside? In the first scenario, investable stocks have probably overshot to the downside versus the global benchmark and thus will very likely outperform from current levels. Near-term performance is likely to be flat-to-down, as investors await hard evidence of a sequential improvement in growth (Chart 17). In the second scenario, investable stocks are at potentially acute near-term risk, but will likely eventually outperform global stocks once activity begins to pick up sharply. In this scenario, the outperformance of Chinese equities will commence later, but would likely still occur by the tail end of our cyclical investment horizon (6-12 months). As a final point, we are not ruling out the possibility of a temporary trade deal between the U.S. and China, as both sides have the incentive to avoid a further escalation and are now showing goodwill towards constructive negotiations. This may change our tactical view on Chinese stocks, but our cyclical view remains focused on China’s domestic policy and economic fundamentals.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      PBC Official: The RRR Cut Aims at Bolstering Real Economy, September 6, 2019 2      China to accelerate the issuance and use of special local government bonds to catalyze effective investment, China State Council, September 4, 2019 3      Please see Emerging Markets Strategy Special Report, “Chinese Infrastructure Investment: A Ramp-Up Ahead?”, dated August 1, 2019, available at ems.bcaresearch.com 4      China’s Local Governments Sell Assets to Make Up for Revenue Loss, Caixin, September 3, 2019 5      http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201909/t20190906_3382239.htm?mc_cid=eb2b199651&mc_eid=9da16a4859 6      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 7      Please see Emerging Markets Strategy Special Report, “China’s Foreign Debt, And A Secret Weapon”, dated September 12, 2019, available at ems.bcaresearch.com 8      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2):Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: The Fed will cut rates by 25bps this week, accompanied by a balanced message on future moves given firm domestic U.S. growth amid global uncertainties. This could trigger additional near-term increases in Treasury yields if the market prices out future expected rate cuts. More likely, higher Treasury yields will manifest via higher inflation expectations, as investors price in Fed accommodation amid the recent acceleration of realized inflation. ECB: The ECB’s easing package last week fell short of market expectations, as policymakers face the operational constraints of cutting already-negative interest rates and restarting asset purchases. Portfolio Recommendations: Return to below-benchmark on overall interest rate duration on a tactical (0-3 months) basis, with global leading economic indicators bottoming and U.S.-China trade tensions easing. Within country allocation, maintain an underweight stance on U.S. Treasuries versus German Bunds on a USD-hedged basis. Feature Dear Client, Next week, we will be publishing a joint Special Report on the U.K. with our colleagues at BCA Foreign Exchange Strategy and BCA Geopolitical Strategy. The report will be sent to clients this Friday, September 20, on the regular publishing day of the other two services. Thus, Global Fixed Income Strategy clients will be receiving their next report a few days early. We will return to our usual publishing schedule on Tuesday, October 1. Best regards, Rob Robis Chart of the WeekA Fundamental Bottoming Of Bond Yields The bond market has been full of surprises over the past year, and the price action so far this month is no exception. The benchmark 10-year U.S. Treasury yield has climbed +42bps from the September 3 inter-day low of 1.43%, while the 10-year German Bund yield also rose by +23bps over that same period, even as the ECB announced a fresh set of policy easing measures last week. There are several possible reasons for this increase in yields: profit-taking in deeply overbought government bond markets; global central bankers delivering incrementally less dovish surprises; and hints of progress in the U.S-China trade negotiations. We prefer a more fundamental explanation – bond markets may be sniffing out an end of the 2019 global growth downturn. The message from the improving trend in both our global leading economic indicator (LEI) and our Duration Indicator is that global growth (Chart of the Week) is stabilizing, which should help boost government bond yields from current depressed levels. The recent attack on oil facilities in Saudi Arabia does represent a near term risk to this potentially more optimistic narrative on the world economy. Our colleagues at BCA Geopolitical Strategy do expect a military response from the U.S., although U.S. President Trump will attempt to keep it limited. A full-blown U.S.-Iran conflict would likely further raise the risk premium on global oil prices, potentially creating the kind of major spike that has preceded past global recessions – an outcome that Trump would prefer to avoid heading into an election year. For now, we prefer to heed the message from our cyclical indicators, which point to additional increases in bond yields in the next few months. For now, we prefer to heed the message from our cyclical indicators, which point to additional increases in bond yields in the next few months, led by some improvement in inflation expectations and a reduction in the amount of monetary easing discounted in markets – most notably, in the U.S. We now see less of a need for the cautious near-term view on overall duration exposure that we’ve maintained since the announcement of fresh U.S. tariffs on China in early August, especially given the recent easing of U.S.-China trade tensions ahead of the next round of talks in early October. Thus, we recommend shifting to a below-benchmark stance on overall portfolio duration on a tactical (0-3 months) basis, bringing that view back in line with our cyclical (up to 12 months) call, which has remained bearish on bonds (see the table on Page 12 for changes to our model bond portfolio). FOMC Preview: 25bps This Week, With No Promises After That While there is still a lot of investor angst over the underlying health of the global economy, the “recession narrative” appears to be receding. The New York Fed’s recession probability model, based on the slope of the U.S. Treasury curve, has seen the odds of a 2020 downturn fall from a peak of 42% in August to 32% today. At the same time, there has been a sharp drop in the number of Google searches involving the word “recession” (Chart 2). Chart 2Hold Off On That Inevitable Recession A similar message can be seen in financial markets, where classic risk-off/save haven assets like gold, and the VIX index have pulled back a bit from recent highs (Chart 3). Government bond volatility measures like the MOVE index remain elevated, though, as fixed income markets continue to price in expectations of low inflation and easier monetary policy – especially in the U.S. Chart 3Yields Discount A Lot Of Risk-Aversion This week’s FOMC meeting, including an update to the committee’s own growth and rate forecasts, will shed light on the Fed’s latest thinking. A modest downgrade of the Fed’s U.S. growth projections is likely given the downturn in the U.S. manufacturing sector. Yet with U.S. financial conditions easing (Chart 4) and the U.S. consumer remaining confident and willing to spend – purely a function of a robust labor market and despite media coverage of the growing threat of recession – the risk is that the Fed does not end up downgrading its growth projections much. Already, the annual growth rate of core U.S. retail sales is up to a solid 5.3%, after the nearly 10% (annualized) surge seen over the June-August period. Chart 4U.S. Domestic Economic Growth Is Rebounding Chart 5U.S. Inflation Is Accelerating Inflation Could Use A Boost A similar story exists in realized U.S. inflation measures, the majority of which are accelerating. Core CPI in August rose to 2.4% on year-over-year basis, after a surge of 3.4% annualized over the previous three months – the fast such rate over such a short window since May 2006 (Chart 5). Core PCE inflation has also picked up, and is now up 1.6% year-over-year and 2.2% – above the Fed’s 2% target – on a 3-month annualized basis. Wage growth, measured using average hourly earnings, continues to grow at a solid 3.6% year-over-year rate. Given these readings, combined with a persistently low unemployment rate, the FOMC is likely to make few (if any) changes to its inflation forecasts at this week’s meeting. Chart 6Stretched Treasury Yields Can Keep Climbing Given the underlying firm trends in the U.S. economic and inflation data, odds are low that the Fed will deliver an incremental dovish surprise to markets. The reverse is more likely. At the same time, the Fed is keenly aware of the fragility of non-U.S. economic growth, and U.S. financial markets, amid the persistent drag on U.S. manufacturing activity and business confidence from the U.S.-China tariff war. Once again, Fed Chair Jerome Powell will have to thread the needle with a message that sounds neither too dovish nor too hawkish. We fully expect another 25bp rate cut to be delivered this week. However, we also expect forward guidance to reflect a balanced outlook for a strong U.S. economy juxtaposed against concern for non-U.S. growth. In other words, the same message the Fed has been giving the markets since mid-year. Given the current stretched momentum of Treasury yields/prices, amid large overweight positioning according to measures like the J.P. Morgan client duration survey, any sign of a less dovish Fed should trigger some increase in Treasury yields (Chart 6). This is especially true with the U.S. Overnight Index Swap (OIS) curve still discounting 71bps of rate cuts over the next twelve months – an amount of easing that is unlikely to be delivered. In our view, though, the bigger near-term threat of rising Treasury yields will not come from the Fed being too hawkish, but from appearing too dovish amid accelerating inflation and firm U.S. economic growth. In our view, though, the bigger near-term threat of rising Treasury yields will not come from the Fed being too hawkish, but from appearing too dovish amid accelerating inflation and firm U.S. economic growth. Market-based inflation expectations remain depressed, with the 10-year TIPS breakeven rate now at 1.68%. That is well below levels consistent with the Fed’s 2% PCE inflation target despite the persistent tightness of the U.S. labor market and the acceleration seen in realized inflation measures. We recommend that clients shift back to a below-benchmark duration stance in the U.S. this week, while maintaining the maximum exposure to TIPS versus nominal Treasuries to position for higher inflation expectations that will also result in some steepening of the Treasury yield curve. Bottom Line: The Fed will cut rates by 25bps this week, accompanied by a balanced message on future moves given firm domestic U.S. growth amid global uncertainties. This could trigger additional near-term increases in Treasury yields if the market prices out future expected rate cuts. More likely, higher Treasury yields will manifest via rising inflation expectations, as investors price in Fed accommodation amid the recent acceleration of realized inflation. ECB: Take It To The Limit One More Time Last week’s much anticipated policy easing announcement by the European Central Bank (ECB) was comprehensive in scope, but disappointing in size. Short-term interest rates were cut, but only through a modest -10bp reduction in the overnight deposit rate. The Asset Purchase Program (APP) was restarted, but only at a pace of €20bn per month, well off the €80bn peak pace of the 2015-18 APP (Chart 7). Chart 7A Relatively Modest Easing Package From The ECB Those new initiatives fell short of the consensus forecast of a -20bp cut and €30bn of new APP. The ECB did introduce some tools to help struggling euro area banks - allowing some portion of banks’ excess reserves to Chart 8No Wonder There Is Disagreement With The ECB avoid the negative deposit rate (a.k.a. “tiering”) and extending the maturity of the TLTRO III program announced earlier this year from two to three years. Nonetheless, the overall stimulus package fell short of a “big bazooka” that did not break new ground on policy instruments (like buying equities in the APP). The biggest change from previous ECB easing initiatives was by making these new programs “open-ended”, with no specific expiration date. Instead, the asset purchases and lower interest rates would be maintained until euro zone inflation sustainably converged to the ECB’s inflation target of just under 2%. With the ECB’s newly revised forecasts calling for headline inflation to only climb to 1.5% by 2021, the new program has already been mockingly branded “QE Forever” by those who do not expect inflation to ever return to 2%. A big reason why the ECB was unable to deliver a bigger package was the disagreement within the ECB Governing Council on the need for more aggressive stimulus. Prior to last week’s meeting, several ECB officials publically voiced their reluctance to restart asset purchases and deliver deeper interest rate cuts, believing that they would have little impact on future euro area growth and inflation. While the opposition to fresh bond buying came from predictable sources like Germany and Austria, there was also an unprecedented level of public dissent after the ECB meeting, with the heads of the Dutch, Austrian and French central banks publically expressing doubts on the effectiveness of the new easing measures. This came after outgoing ECB President Mario Draghi noted in his post-meeting press conference last week that the consensus on restarting APP within the Governing Council was so broad that “there was no need to take a vote.” Given the diverging economic and inflation trends within the euro area, it should not be a surprise that a broad consensus within the Governing Council was hard to produce. For example, Germany is suffering through a much deeper manufacturing downturn than the other major euro area countries, judging by the trends in manufacturing PMIs (Chart 8). At the same time, Germany has a much lower unemployment rate and higher inflation rates than Italy and Spain. Focusing only on the German manufacturing downturn when setting monetary policy may produce results that are too stimulative – especially when the services sides of euro area economies appear in better shape (most notably in Germany). The ECB will run into some difficulties on running a “QE Forever” program of asset purchases given the current self-imposed constraints on the APP. Looking ahead, the ECB will run into some difficulties on running a “QE Forever” program of asset purchases given the current self-imposed constraints on the APP. The ECB cannot own more than 33% of the outstanding pubic debt of any single country (counting both sovereign debt and government agency bonds). At the moment, the ECB ownership shares are below that 33% threshold for the largest countries, based on our calculations that are presented in Chart 9. Chart 9"QE Forever" Is Not Credible Under Current Constraints However, that 33% limit will be threatened by the end of 2020 in several countries: the ECB will buy €15bn per month of government bonds under the new APP1 the ECB continues to allocate its bond buying in line with the size of each country (as determined by the ECB Capital Key) the stock of debt eligible for the APP expands at the same rate as consensus forecasts of nominal GDP growth Draghi also noted in his press conference that there was “relevant headroom to go on for quite a long time at this rhythm without the need to raise the discussion about limits.”2 We disagree, as our calculations show that the 33% threshold will be at threat of being reached by the end of next year in Germany, Spain, the Netherlands, Finland & Ireland (see the gray bars of Chart 9). If the ECB truly wants to commit itself to buying bonds until inflation returns to just under 2%, however long that takes, then one of three things must happen: the ECB must raise the issuer limit from 33% the ECB must allocate its bond buying using different weights than the Capital Key the supply of available government debt must increase through easier fiscal policy. Chart 10The ECB Will Have To Raise Issuer Limits To BoJ Levels Of those three options, altering the country weights away from the Capital Key is the most politically contentious, as it would involve more purchases from countries with weaker government finances, like Italy and Spain. Raising the issuer limit from 33% is a more realistic option, as that is a completely self-imposed rule with no economic grounds, although it raises the risk of the ECB bond ownership approaching Bank of Japan type levels (Chart 10). Solving the ECB’s “headroom” constraint by issuing more government debt through fiscal expansion is the one option that could truly help Europe get out of its low inflation trap. Yet that is also an option fraught with political tension in places like Germany where keeping low levels of government debt has been a politically popular choice. With the new ECB President, Christine Lagarde, set to take over from Draghi in November, the policy debate within Europe will turn toward the need for more fiscal stimulus. Already, there have been media reports suggesting the German government is considering new stimulus measures to boost a Germany economy that is now in a technical recession. Solving the ECB’s “headroom” constraint by issuing more government debt through fiscal expansion is the one option that could truly help Europe get out of its low inflation trap. Chart 11Inflation Expectations & Bund Yields Are Stabilizing If the ECB’s APP capacity issues are not eventually resolved, then the market will soon come to the realization that there can be no “QE Forever”. Combined with the known limitations on pushing policy rates deeper into negative territory - for fears of reaching a “reversal rate” that will cause banks to horde cash and make fewer loans - there is limited scope for additional declines in euro area bond yields from the deeply depressed current levels under the new policy announcements made last week. For now, we continue to favor overweighting core euro area government debt in global fixed income portfolios, on a currency-hedged basis. Despite the persistent negative yields on offer, those can be transformed into positive-yielding assets when the currency exposure is swapped into U.S. dollars. Furthermore, the so-called “convexity buying” of longer-dated euro area government bonds by asset-liability managers like insurers and pension funds will continue to anchor the long-end of euro area yield curves (Chart 11) – although that same factor can potentially hyper-charge a rise in yields as convexity buying turns into convexity selling if the economic fundamentals were to swing in a bond-bearish fashion (which is a topic we plan on covering in a future report). Bottom Line: The ECB’s easing package last week fell short of market expectations, as policymakers face the operational limits of cutting already-negative interest rates and restarting asset purchases. Yet for now, the economic/inflation backdrop in Europe remains bond friendly. Maintain a strategic overweight stance on Germany versus the U.S. in global government bond portfolios, with Bunds still supported by ECB buying and with USD-hedged Bund yields continuing to offer a yield pickup over Treasuries.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The other €5bn per month is assumed to go towards the purchases of corporate debt. 2 The full transcript of Draghi’s press conference can be found here: https://www.ecb.europa.eu/press/pressconf/2019/html/ecb.is190912~658eb51d68.en.htm The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The ebbing of U.S. / China trade tensions and swing toward positive data surprises are enough for us to re-initiate a below-benchmark duration recommendation, on both tactical (0-3 month) and cyclical (6-12 month) time horizons. While not our base case, a continued deterioration in the Manufacturing PMI or CRB Raw Industrials, or a significant appreciation of the U.S. dollar would cause us to question our view. Credit: Corporate debt levels are elevated, but still-low inflation expectations will ensure that monetary conditions remain accommodative for the time being. Easy Fed policy will support interest coverage ratios and prevent banks from tightening lending standards. Stay overweight corporate bonds, focusing on the Baa and high-yield credit tiers. Fed: The Fed will cut rates by 25 basis points tomorrow and Chairman Powell will do his best to sound dovish and prevent a tightening of financial conditions. Core inflation has strengthened in recent months, but the Fed needs to see a rebound in inflation expectations before turning hawkish. Feature Move Back To Below-Benchmark Portfolio Duration The sensitivity of bond yields to U.S./China trade policy was on full display last week. President Trump took significant steps to de-escalate tensions between the two nations, delaying the October 1st tariff hike and scheduling talks between principal negotiators for October. The result is that the bond market sold off dramatically. The 10-year Treasury yield rose from 1.55% at the start of the week to 1.90% as of last Friday. As we go to press, the yield has fallen back to 1.85% in response to the drone attacks in Saudi Arabia and resulting spike in oil prices. Chart 1Has The Tide Turned? Our Geopolitical Strategy service discussed the near-term outlook for U.S. / China trade negotiations in last week’s report.1 Our main takeaway is that the President has shifted into dealmaker mode, hoping to secure some “wins” in advance of next year’s election. Talk of a looming recession in the mainstream media is doubtless also encouraging the President to adopt a more conciliatory strategy. Our political strategists view a comprehensive U.S. / China trade agreement as unlikely. But if the U.S. and China can reach a détente where tariffs are no longer rising every few months and the immediate threat to economic growth dissipates, then U.S. bond yields have a lot of upside. Chart 1 shows that the 10-year Treasury yield fell much more sharply in recent months than would have been expected given the U.S. economic data. The chart also shows that economic data are now beating expectations for the first time since February. Positive data surprises usually coincide with rising Treasury yields, and the chart suggests that yields still have a lot of catching-up to do. The de-escalation of trade tensions and shift in data surprises is enough for us to remove our tactical “at benchmark” duration stance, which had been in place since August 6. Investors should keep portfolio duration low on both tactical (0-3 month) and cyclical (6-12 month) time horizons. Risks To The Duration View There are three main risks to our below-benchmark duration positioning. The first is that the global manufacturing data – Manufacturing PMIs and the CRB Raw Industrials index – have not yet rebounded (Chart 2). We have written extensively about why we expect a bounce-back before the end of the year, and an ebbing of U.S. / China trade tensions will only speed that process along, as firms gain more confidence in the outlook and initiate long-delayed investments.2 However, until we actually see the data improve we cannot be certain. It’s notable, and concerning, that the ratio between the CRB Raw Industrials index and Gold did not increase alongside Treasury yields during the past week (Chart 2, bottom panel). If the dollar continues to appreciate as Treasury yields move up, it will limit how high yields rise.  The second risk to our view comes from the dollar. If it continues to appreciate as Treasury yields move up, it will limit how high yields rise. Treasury yields can increase alongside a stronger dollar when global leading indicators are improving, as was the case in the second half of 2016 (Chart 3). But a strong dollar will eventually undermine global growth and cap the upside in yields. Chart 2Risk 1: Global Manufacturing Still Weak Chart 3Risk 2: Stronger Dollar The third risk is that the recent attack on Saudi oil installations prompts a military response from the U.S. government that escalates into all-out war. The lesson from the oil crash of 2014 is that any negative effects on the U.S. consumer from a spike in the oil price will be offset by greater investment from U.S. energy firms. However, if the situation dissolves into a significant military conflict, then U.S. bonds would benefit from flight to quality flows. Our Geopolitical and Commodity teams discussed the still-unfolding situation in a Special Alert yesterday.3   Bottom Line: The ebbing of U.S. / China trade tensions and swing toward positive data surprises are enough for us to re-initiate a below-benchmark duration recommendation, on both tactical (0-3 month) and cyclical (6-12 month) time horizons. While not our base case, a continued deterioration in the Manufacturing PMI or CRB Raw Industrials, or a significant appreciation of the U.S. dollar would cause us to question our view.   Corporate Bonds: Weak Balance Sheets Vs. Easy Money The slope of the yield curve is an important and useful indicator for corporate bond investors. In fact, our research has demonstrated that corporate bond excess returns versus Treasuries tend to be highest early in the recovery when the yield curve is steep. On the flipside, we’ve also shown that an inverted yield curve is often a good signal to scale back exposure.4 Corporate balance sheets are highly levered today, as they were in the mid-1990s. For this purpose, our preferred measure of the yield curve has been the 3-year/10-year slope, calculated on a monthly basis using average daily closing values. Chart 4 shows this slope with vertical lines denoting the first inversion of each cycle. Notice that we have not yet received an inversion signal from this measure in the current cycle, but it is getting close. Chart 4Yield Curve & Corporate Spreads Even if we get an inversion signal in the next few months, Chart 4 reveals an interesting contrast between the mid-2000s cycle and the mid-1990s cycle. In the mid-1990s, 3/10 curve inversion was an excellent signal to reduce corporate credit exposure. Spreads widened almost immediately, and didn’t peak until four years later. Conversely, spreads continued to tighten for another year after the yield curve inverted in 2006. So how should we view the current cycle in relation to these prior two episodes? Should we expect further outperformance after the yield curve inverts, as in the mid-2000s? Or should we prepare to reduce corporate bond exposure as soon as the yield curve sends a signal, as in the 1990s? Balance Sheets Are In Poor Health … Chart 5Firms Carrying A lot Of Debt The first thing to consider is how corporate balance sheets stack up compared to each of these prior two episodes. Chart 5 makes it apparent that balance sheets are highly levered today, as they were in the mid-1990s. Net debt-to-EBITDA for the median high-yield firm in our dynamic bottom-up sample is above 4.0x, even higher than in the late 1990s. Similarly, the median firm’s debt-to-assets ratio is reminiscent of the 1990s. Chart 5 clearly shows that balance sheets were in poor health in the 1990s, and are in a similar state today. This is in sharp contrast to the mid-2000s, when balance sheets were pristine. The sole exception is interest coverage, which remains robust (Chart 5, bottom panel). This is the result of still-accommodative monetary policy (more on this below). … But The Monetary Environment Is Supportive While today’s corporate balance sheets have more in common with the mid-1990s than the mid-2000s, today’s monetary environment looks more like the mid-2000s, and is probably even more supportive. Chart 6Supportive Monetary Environment: Reminiscent Of The Mid-2000s Chart 6 shows that when the yield curve inverted in the 1990s, banks’ commercial & industrial (C&I) lending standards were on the cusp of tightening, as were the terms that banks offered on C&I loans. In contrast, C&I lending standards and loan terms continued to ease for some time after the curve inverted in the mid-2000s. Today, C&I lending standards and C&I loan terms are both in “net easing” territory. But most crucially, inflation expectations are extremely depressed (Chart 6, bottom panel). Low inflation expectations mean that the Fed must ensure that monetary policy stays accommodative until inflation expectations are re-anchored at levels closer to its target. Accommodative Fed policy will keep firms’ interest costs down, and give lenders the confidence to extend credit, even if firms are already loaded with debt. Bringing it all together, we find that both credit quality metrics and monetary indicators help explain the corporate default rate (Chart 7). Our top-down measure of gross leverage (total debt over pre-tax profits) lines up well with the default rate over time, but has diverged during the past few years (Chart 7, top panel). Meanwhile, C&I lending standards also correlate tightly with the default rate, and this relationship continues to track (Chart 7, panel 3). Chart 7Drivers Of The Corporate Default Rate Overall, we find the divergence between gross leverage and the default rate concerning, and reminiscent of 2007/08 when it predicted a surge in the default rate. However, unlike in 2007/08, lending standards are moving deeper into “net easing” territory and interest coverage remains steady. Considering all the evidence, we are inclined to remain bullish on corporate credit spreads for the time being. Yes, corporate debt levels are a worry, as they were in the 1990s. But, with inflation expectations still very low, the Fed has a strong incentive to keep policy easy. Historically, banks do not tighten lending standards unless the monetary environment is restrictive. Our sense is that, in this cycle, banks will turn a blind eye to corporate debt levels until inflation expectations rise and the Fed moves interest rates into restrictive territory. Credit Investment Strategy Chart 8Focus On The Baa And High-Yield Credit Tiers Our relatively bullish assessment of the credit cycle means that we will continue to abide by the spread targets we introduced in February.5 To obtain those targets we calculated the median 12-month breakeven spread for each credit tier during periods when the yield curve was very flat (less than 50 bps), but not yet inverted.6  We then converted those breakeven spreads into option-adjusted spread targets using current index duration and the current index credit rating distribution. Chart 8 shows that investment grade spreads are slightly above target, but this is only due to the cheapness of Baa-rated debt. Aaa, Aa and A-rated credits all trade at spreads below our targets, and we recommend focusing investment grade exposure on the Baa space. Chart 8 also shows that high-yield spreads are much more attractive relative to target. This is partly because the negatively convex nature of high-yield debt means that index duration fell sharply as bonds rallied this year (Chart 8, bottom panel). All else equal, lower index duration means that more spread widening is required before investors see losses. Thus, spreads appear more attractive. Bottom Line: Corporate debt levels are elevated, but still-low inflation expectations will ensure that monetary conditions remain accommodative for the time being. Easy Fed policy will support interest coverage ratios and prevent banks from tightening lending standards. Stay overweight corporate bonds, focusing on the Baa and high-yield credit tiers. FOMC Preview: Fed Will Do Its Best To Stay Dovish The results of this week’s FOMC meeting will be made public tomorrow afternoon. A 25 basis point rate cut is widely anticipated, and we expect that is what will be delivered. A 25 basis point rate cut is widely anticipated, and we expect that is what will be delivered. Judging from recent remarks, Fed Chairman Jerome Powell is well aware that easy financial conditions will encourage a recovery in economic growth.7 He also understands that in order for financial conditions to stay easy, the market must continue to believe that monetary policy is supportive. We therefore think that Chairman Powell will do everything he can to prevent a hawkish surprise following tomorrow’s FOMC statement and press conference. However, the Chairman cannot control the placement of each FOMC participant’s interest rate forecast (or “dot”), and there is a risk that the end-of-2019 forecasts don’t fall enough to appease markets. Chart 9 shows the fed funds rate along with a projection based on current pricing in the fed funds futures market. It shows that the market expects a 25 bps rate cut tomorrow, followed by one more 25 bps cut before the end of the year. We don’t expect the majority of FOMC participants to forecast such a dovish outcome, but as long as a significant number of participants forecast one more cut before the end of the year, a hawkish surprise should be avoided. Chart 9Can The Fed Avoid Sounding Hawkish? Case in point, the Fed avoided a hawkish surprise following the June meeting. Heading into that meeting the market was priced for an end-of-2019 funds rate of 1.75% (denoted by the ‘X’ in Chart 9). The June FOMC dots show that 7 FOMC participants expected a similar outcome (also shown in Chart 9). If around 7 participants place their 2019 dot in the 1.50%-1.75% range following tomorrow’s meeting, it should be enough to prevent a hawkish surprise. Will Strong Inflation Sway The Fed? There has been some speculation that the recent spate of strong inflation data might prevent the Fed from delivering a sufficiently dovish message. We think this is unlikely. It’s true that core inflation has rebounded sharply, but inflation expectations remain downtrodden (Chart 10). At this juncture, the Fed is principally concerned with re-anchoring inflation expectations near target levels. It may require an overshoot of the actual inflation target to achieve this goal. Investors should focus more on inflation expectations to assess Fed policy going forward. Chart 10Still Well Anchored? Chart 11Unsustainable Uptrend in Goods   Further, if we dig into the details of the recent inflation prints, we find some reason to believe that the recent uptrend is not sustainable. Chart 11 shows that a substantial portion of inflation’s rise has been driven by the core goods component, which tracks non-oil import prices with a lag of about 1½ years (Chart 11, panel 2). For their part, import prices have already rolled over and will continue to decelerate unless we see a significant depreciation of the dollar (Chart 12). Chart 12Import Prices & The Dollar Bottom Line: The Fed will cut rates by 25 basis points tomorrow and Chairman Powell will do his best to sound dovish and prevent a tightening of financial conditions. Core inflation has strengthened in recent months, but the Fed needs to see a rebound in inflation expectations before turning hawkish.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “Trump’s Tactical Retreat”, dated September 13, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?”, dated August 20, 2019, available at usbs.bcaresearch.com 3 Please see Commodity & Energy Strategy / Geopolitical Strategy Special Alert, “Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response”, dated September 16, 2019, available at ces.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required before a corporate bond sees losses versus a duration-matched Treasury bond on a 12-month horizon. It can be calculated roughly as the option-adjusted spread per unit of duration. 7  https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The ECB loaded a bazooka, and core Eurozone yields rose: The ECB surprised dovishly last Thursday, and European bond yields duly fell … for an hour. Then they began to back up as fast as they fell, and when Friday’s trading ended, only Greek and Italian yields were lower than where they started. The market action supports our contention that things are not so bad, assuming the worst-case trade scenarios do not materialize: Underpinned by a robust labor market, the U.S. should have little trouble growing at a trend pace over the next twelve months. Meanwhile, the global economy may be in the process of turning. Reversals within the U.S. equity market have gotten a lot of attention so far this month, but it’s too early to claim that a broad factor inflection is underway: If global growth prospects have bottomed, defensive sectors’ outperformance is due to reverse, which will cause havoc for momentum strategies. It is premature to call for a value revival, however. Feature Maybe long Treasury yields aren’t going to zero after all. After bottoming just below 1.43% the day after Labor Day, the 10-year Treasury yield surged 45 basis points across eight sessions as of Friday’s lunchtime peak (Chart 1). The move has been enough to retrace better than three-fifths of its steep slide from mid-July to the beginning of September, but relative to the extended plunge from 3.24% that began last November, the bounce barely registers. Chart 1Up, Up And Away Chart 2Pulled Lower By Expected Rate Cuts... The takeaway is that it’s important to keep the moves in context. Just as the collapse in Treasury yields didn’t indicate that the U.S. economy was headed for an imminent recession, their modest, if rapid, recovery doesn’t indicate that all the dark clouds are gone from the horizon. From a purely domestic perspective, the 180-basis-point (“bps”) peak-to-trough decline in the 10-year Treasury yield unfolded nearly step-for-step with an equivalent decline in the expected fed funds rate twelve months out (Chart 2). Since a 1.25% target fed funds rate this time next year is incompatible with our view of the economy, we expect rates will move higher. The ECB committed itself to accommodation for longer than markets had expected; … Chart 3...And Other Sovereign Yields Chart 4Better Times Ahead? The Treasury market doesn’t exist in a vacuum, however. Yield moves in similarly-rated sovereign bonds have an effect on Treasuries, and declines in European sovereign yields have exerted a gravitational pull all year long (Chart 3). The backup in yields that followed the ECB’s dovish surprise on Thursday suggests that Eurozone sovereign bond markets may have bought the rumor and sold the news. If global growth is in the process of bottoming, as global leading indicators suggest, falling yields would run counter to the fundamental backdrop (Chart 4). You May Fire When Ready, Draghi To judge by the spate of columns urging helicopter-style accommodation measures, the expectations bar for the European Central Bank’s long-awaited September meeting had been set pretty high. The cut in the ECB’s deposit facility rate to -0.5% from -0.4%, with provisions to mitigate the pressure negative rates exert on banks, was in line with the market consensus, as was a resumption of quantitative easing. Investors did not foresee that the ECB would embark on open-ended bond purchases, however, a plan quickly labeled “QE Infinity.” The ECB also dumped its no-hikes-before-mid-2020 guidance – now it won’t move until the inflation outlook “robustly” moves toward its 2% target – and lengthened the maturities on TLTRO loans while lowering their rates.1 The surprise indicated that the ECB is taking the slowdown seriously, at home (most evident in Germany, which is flirting with recession after a quarter-over-quarter GDP contraction) and abroad. It is premature to declare the action a flop, as headline writers were quick to do, citing the evanescent decline in core bond yields and the euro, because QE impacts are subject to several factors. Sovereign yields can rise on QE announcements if markets judge the impact of relaxed inflation vigilance will outweigh the impact of the entry of a new, price-insensitive buyer to the marketplace. As long as real yields fall, the central bank will have achieved its goal. … if it develops that the incremental accommodation wasn’t necessary, equities and spread product should reap the benefits. U.S. investors are mostly concerned with the impact on global markets and the global economy. Even if nominal sovereign yields have bottomed and competitive devaluation has neutered the currency channel, incremental easing should boost risk assets’ prospects, via pushing incumbent sovereign holders into spread product (the portfolio balance effect), promoting business and consumer confidence, incentivizing bank lending, and nudging other central banks (like Denmark’s, which immediately cut its policy rate in response) to ease monetary conditions themselves (Figure 1). On those counts, we view the ECB’s surprise as modestly improving the prospects for risk assets. TINA is alive and well. Figure 1Monetary Policy And The Economy The Employment Situation We have repeatedly cited the robustness of the labor market as a reason for not giving up on the U.S. economy, or equities and spread product. If expanding payrolls and increasing compensation can keep consumption growing at just a 2% clip, the probability of a U.S. recession, and of an equity bear market and a new default cycle, is fairly slim. If the labor market isn’t as strong as we’ve judged, more defensive portfolio positioning may be in order. Since the beginning of the second quarter, the monthly employment situation reports have revealed a slowing in hiring activity, halting the quickening that stretched from last year through the end of the first quarter (Chart 5). The slowing trend is less concerning than it might appear to be on its face. The current expansion, 122 months old and counting, is the longest on record, and now that it has already drawn considerable numbers of people back into the labor force and back to work, it has become increasingly difficult to find and attract new workers. Even the current monthly pace of job gains, 156,000 over the last three months, still puts downward pressure on the unemployment rate, as it takes less than 110,000 new jobs to maintain the status quo. With net job gains outpacing new entrants into the labor force, wages should rise. Average hourly earnings rose 3.2% in August on a year-over-year basis, though the 0.4% month-over-month gain suggests they may be about to challenge the top end of the tight 3.1-3.2% range that’s prevailed all year. Investors’ and economists’ patience with the Phillips Curve is increasingly wearing thin, as they wait for the decline in the unemployment rate to show up in wage gains, but we consider the underlying supply-demand relationship to be immutable. The prime-age employment-to-population ratio hit an 11-year high in August, and is solidly back in the middle of the range that has prevailed over the 30 years that female participation gains have stabilized (Chart 6). Chart 5Slower Payroll Gains... Chart 6...Will Still Tighten The Labor Market Chart 7The Unkinked Phillips Curve The prime-age employment-to-population ratio is an important measure for the Phillips Curve because it exhibits a consistent linear relationship with wage gains. The fit between the non-employment-to-population ratio (1 minus the employment-to-population ratio) and the employment cost index (Chart 7, top panel) is a little tighter than the fit with average hourly earnings (Chart 7, bottom panel), but both regression equations project an annual increase in wages of 3.3% at the current 20% (1-80%) level, and a 7-bps gain for every 20-bps decline in the prime-age non-employment-to-population ratio. Given that our payrolls model projects a pickup in the pace of hiring (Chart 8, top panel), and the quits rate just moved off of its extended plateau (Chart 9), upward pressure on wages will continue to build.   Chart 8Demand For Workers Is Still Solid Chart 9Movin' On Up Bottom Line: Payroll gains are slowing, but they remain robust enough to push the key prime-age employment-to-population ratio higher, and exert upward pressure on wages.   Factor Rotation Chart 10Momentum Hits The Wall,... Reversals within the U.S. equity market have been drawing increasing amounts of attention, as momentum stocks have hit a wall while long-suffering value stocks have begun to peel themselves off the canvas (Chart 10). We can easily see a scenario in which the momentum factor has a very difficult time, if relative performance shifts from defensive sectors to cyclical sectors as investors begin to perceive that they have been overly pessimistic about the domestic and global business cycle, and cease to hide in bond proxies like Utilities and REITs. Given the defensives’ run of outperformance over the last year, momentum indexes disproportionately favor them over cyclicals. The S&P 500, MidCap 400 and SmallCap 600 Momentum Indexes all show a pronounced defensives bias, with Health Care, Utilities and Real Estate all commanding double their baseline weight in at least one index (Table 1), making S&P’s momentum indexes vulnerable to a defensives-to-cyclicals rotation. Table 1The Dullest Stocks Have Been The Hottest Over the last three years, we have thought a lot about the value factor, asking how it should be defined, which financial statement metrics indicate its presence, and the business and monetary policy cycle backdrops that are most conducive to its outperformance. Low-priced stocks have been in a punishing extended slump versus high-priced stocks since early 2007 (Chart 11), and we think they have yet to bottom. The recent value stock rally has been a function of higher 10-year Treasury yields, and banks’ (which account for an outsized share of popular value benchmarks) recent tendency to trade in lockstep with them. We do not think a two-week backup in yields is the stuff that a genuine value factor inflection point is made of. Chart 11...But The Value Factor Has Yet To Turn A detailed explanation of our rationale is beyond the scope of this report,2 but the following points summarize our take: The value factor has gotten killed since the crisis, but we doubt that it’s dead. Value has historically treaded water during bull markets, and shined in bear markets. The fed funds rate cycle is the best predictor of value’s relative performance. Value has historically crushed the overall market when monetary policy is restrictive. The most popular style indexes have barely any factor merit. The S&P 500’s Growth and Value indexes are little more than Tech and Financials proxies. Value will shine again, but not until monetary policy is restrictive. If the Fed doesn’t hike the fed funds rate above the equilibrium fed funds rate until 2021, value investors will have to gut out another year-plus of underperformance. Bottom Line: The momentum factor could suffer in the near term if cyclicals reassert primacy over formerly hot defensives. The value factor’s fortunes will not turn for at least another year. Investment Implications We understand the discomfort of investors who feel like ZIRP, NIRP and QE have obliterated normal investing relationships. Disorienting as it has been to see nominal Treasury returns shrivel, the rising tide of negative-yielding bonds is like a surreal detail from a David Lynch movie. The investment world has indeed turned upside-down when investors buy bonds for capital gains to offset the interest they have to pay for the privilege of lending. Austrian School advocates are surely not the only dearly departed investing veterans rolling in their graves. It’s not the environment we wanted, but it’s the environment we got, so we’re going to buck up and do our best to squeeze excess returns out of it. We have to invest in the markets we have, however, not the markets we want. It does neither ourselves nor our clients any good to throw up our hands, bitterly lament our fate and wish ill upon the exponents of the activist, ultra-accommodative approach to central banking that is now in fashion. Some old relationships still apply, and the combination of a quietly improving global economic backdrop with incremental monetary accommodation everywhere one turns is good for risk assets. We continue to recommend that investors resist the urge to get defensive before the excess-return window closes for this cycle. We are not advocating that investors let their guard down, and assume that central banks will be able to keep the plates spinning indefinitely. They will not – monetary interventions are a poor substitute for organic growth in productivity or the size of the working-age population, and so are inefficiently directed fiscal spending programs – but we bet they can through the next quarterly or annual period over which an institutional manager is going to be evaluated. The upshot is that investors should remain especially vigilant for signs of trouble, and be prepared to act more tactically than normal to adjust their portfolios, but shouldn’t de-risk them yet, lest they miss the last of the fat-year returns they’ll need to tide themselves over during the coming lean years.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Targeted longer-term refinancing operations (TLTROs) are ECB loans to banks intended to encourage lending to households and non-financial corporations. 2 Interested readers should see the May 16, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, “Smart-Beta ETF Selection Update – Is Value Still Worth It?,” the October 2018 Bank Credit Analyst Special Report, “Is It Time To Buy Value Stocks?,” and the October 2, 2018 U.S. Investment Strategy Special Report, “When Will Value Work Again?,” available at etf.bcaresearch.com, www.bcaresearch.com and usis.bcaresearch.com, respectively.

Highlights Growth & Yields: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. Data Surprises & Yields: The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. Duration Strategy: We still recommend investors to stick to a neutral (at benchmark) stance on overall portfolio duration in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding, and U.S.-China trade tensions remain a lingering concern. On a cyclical horizon (6-12 months), however, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields will rise more sustainably, justifying reduced duration exposure. Feature Chart of the WeekA Potential Bottoming Of Growth & Yields Is The Great Global Bond Rally of 2019 finally running out of gas? Government bond yields in the major developed economies have stabilized and are now starting to drift a bit higher. Benchmark 10-year yields are all up by healthy amounts from the inter-day lows reached on September 3rd (U.S. +18bps, Germany +17bps, U.K. +24bps, Canada +24bps). Yields remain well below intermediate term trend measures like the 200-day moving average, however, suggesting that these rebounds may only be corrective in nature and not yet the start of a more sustained cyclical move higher. Reliable economic data like our global manufacturing PMI are still falling and remain at levels suggesting weakening global growth. Yet on a rate-of-change basis, the pace of the decline in the PMI is fading, indicating that the worst of the downturn is likely behind us. A bottoming of the downward momentum of the PMI typically coincides with fading downward momentum in bond yields (Chart of the Week), which suggests that, at a minimum, bond yields are unlikely to fall below the recent lows. A similar signal is given by our global leading economic indicator (LEI), which has clearly bottomed and is now starting to drift higher. We shifted to a tactically neutral stance on global duration exposure back in early August, based on our near-term concerns that the ratcheting up of U.S.-China trade tensions through new tariffs would further raise economic uncertainty and heighten the demand for safe assets like government bonds – especially given the decline in global manufacturing activity. Last week’s announcement that U.S.-China trade talks would resume in early October was a positive step towards a potential de-escalation of trade tensions, which did help provide a pro-risk lift to global bond yields (at least for one day). For now, however, we are staying with a near-term neutral view on duration until we see more concrete signs of progress from the October 5 U.S.-China trade meetings in D.C. The heightened political drama in the U.K. is another reason to be cautious, with the October 31 Brexit deadline – and potentially a U.K. election before then – fast approaching (NOTE: we will be publishing a joint Special Report on the U.K. with our colleagues at Foreign Exchange Strategy and Geopolitical Strategy on September 20). More fundamentally, we will look to reduce our recommended duration exposure back to below-benchmark once global manufacturing data (i.e. U.S. ISM, Markit PMIs) and economic sentiment data (i.e. global ZEW, German IFO) stabilize – an outcome that grows increasingly likely given the signs of improvement we are seeing in the global LEI. Finding The Biggest Disagreements Between Economic Data & Bond Yields One time-tested way to identify a potential cyclical market top or bottom, for any asset class and not just bonds, is to look for divergences in prices from fundamentals. For example, when bond yields continue to fall despite signs that economic data are starting to improve (or, at least, when there is less data underperforming expectations). We can see such a divergence today when looking at bond yields versus data surprise indices. The most visible divergences between better data surprises and low bond yields are in the U.S., Australia, Canada and New Zealand. In Charts 2 & 3, we show the 26-week change in the benchmark 10-year government bond yield (in basis points) versus the widely followed Citigroup Economic Data Surprise Indices for the U.S., euro area, Japan, the U.K., Australia, Canada, New Zealand and Sweden The broad relationship is that yields fall faster when data is weaker than expected, and vice versa. The relationship is stronger in some countries like the U.S. and the U.K., and very weak in Japan, but we can still look for divergences between yield changes and data surprises for signs of bond yields deviating from economic growth. Chart 2Data Surprises Diverging From Yields In The U.S. … Chart 3… And In "The Dollar Bloc" The most visible such divergences are in the U.S., Japan, Australia, Canada and New Zealand; in those countries, more data releases have been surprising to the upside versus consensus forecasts of late, yet bond yields have been falling at a very rapid rate. In the euro area, the U.K. and Sweden, data has been disappointing versus expectations, justifying the rapid move down in bond yields in those countries purely from an economic growth perspective. For all countries shown, interest rate markets are now priced for aggressive monetary easing. Our 12-month discounters, based on pricing from Overnight Index Swap (OIS) curves, all show that money markets expect central banks to ease policy over the next year. Our discounters remain highly correlated to the level of government bond yields (Charts 4 & 5), which means that the biggest risk to the Great Global Bond Rally of 2019 is that policymakers do not deliver the full amount of easing discounted by markets. Chart 4Bond Yields Are Vulnerable To A Rebound … Chart 5… Given Overly Dovish Policy Expectations That risk looks greatest in countries where there is both a divergence between improving data surprises and low bond yields AND a significant amount of interest rate cuts priced into the OIS curve – like the U.S. (98bps of cuts discounted), Australia (42bps), Canada (32bps) and New Zealand (33bps). Japan (13bps), the euro area (22bps) and Sweden (4bps) are all cases where central bank policy rates (and bond yields) are negative but where additional rate cuts are still discounted. Data continues to disappoint to the downside in the euro area and Sweden, however, suggesting that bond yields there are less at risk of a corrective snapback. A similar argument applies in the U.K. (25bps), where there is not a divergence between weak data and falling Gilt yields. Given the weak correlation between data surprises and changes in bond yields in Japan – an unsurprising outcome given the Bank of Japan’s outright manipulation of JGB yields – we find it difficult to make any conclusions on the next move in yields based solely on an analysis of Japanese data surprises. That risk of higher bond yields is greatest in countries where data surprises are diverging from bond yields AND a significant amount of interest rate cuts are discounted. Bottom Line: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. The Increasingly Schizophrenic Nature Of Global Central Banks The dovish turn of global monetary policy in 2019 has been fairly limited in terms of the size of cuts, but broad in terms of the number of countries that have delivered cuts. Our Global Monetary Easing Indicator (GMEI), which measures the percentage of central banks (out of a list of 29) that have cut policy rates from three months earlier, is a simple way to measure the “breadth” of the global monetary policy cycle. In Chart 6, we compare the GMEI (shown on an inverted scale) to our global LEI. Historically, the GMEI has peaked around three months after the global LEI troughs. Afterward, facing prospects of improving growth, central banks gradually took their feet off the gas pedal, with the GMEI moving to zero as the global LEI continued to climb. Chart 6Introducing Our Global Monetary Easing Indicator The ups and downs of central banker actions have become more complicated since 2008. After the financial crisis, policymakers had to keep rates at or near the zero lower bound. For the Fed looking over at its Japanese counterpart, the prospect of keeping rates too low for too long, and thereby eventually losing the ability to stimulate the economy through rate cuts in the next downturn, was a fearful one. At the same time, creating overly easy financial conditions and indirectly causing the next asset bubble was another concern for policymakers in the aftermath of the financial crisis. After 2016, central bank behavior became particularly misguided. This “bi-polar” policy environment clearly caused a change in the reaction function of global central banks. Post-crisis, they have been slower to react to signs of global weakness. In 2016, for example, the GMEI peaked a full six months after the trough in the LEI – a longer reaction time compared to previous cycles. Even when they did react, however, it was at a lower intensity, with smaller easings by fewer banks, compared to previous cycles After 2016, however, central bank behavior became particularly misguided. The subsequent monetary tightening was clearly too abrupt. Investor sentiment and expectations of global growth, captured by our GFIS duration indicator (Chart 7), were on their way down while global central banks were all too eager to stop easing, ignoring the data showing signs of global weakness – especially from China. Chart 7Central Banks Are Zigging When They Should Be Zagging By June 2018, none of the central banks included in the GMEI were easing, despite the global LEI having peaked six months earlier. In September 2018, despite facing persistent global weakness – the global manufacturing PMI had fallen from its peak of 54.4 nine months earlier to 52.1 and the global LEI was already in negative territory indicating more weakness to come – only a meagre 3% of central banks had begun stimulating. The Fed exemplified this complacency with its rate hike in December 2018 and its refusal to clearly pivot in a dovish direction until three months later. When they ultimately delivered a rate cut in late July of this year, it was clear they had waited too long. Chart 8How Will Dovish Policymakers Respond To Improving Growth? Globally, the overall policy response was non-existent all the way until May 2019, when central banks finally got with the program and scrambled to ease. Now, with the Fed having cut rates and facing the possibility of further rate cuts (possibly hastened by the Tweeter-in-Chief), global central bankers will not want to be left behind, lest they suffer unwanted currency strength and forgo export competitiveness. However, they might be once again misreading the data and the global easing cycle might be much closer to its end than its beginning. BCA’s Chief Global Strategist, Peter Berezin, has noted that global manufacturing cycles average three years from peak to peak. As the last growth cycle began in late spring of 2017, this means that we are likely at the bottom of the current cycle and therefore, global growth should start to pick up soon. This message is reinforced by our Global LEI diffusion index (Chart 8), which indicates that the Global LEI has put in a bottom and will continue climbing higher in the coming months. The easing of global financial conditions, and the lagged impact of China’s policy stimulus measures from earlier in 2019, corroborate the message from the global LEI. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. A pick up in the global LEI, in turn, suggests that the global PMI will follow and should soon move higher, with a lead time of six months based on past cycles (as we show in the bottom panel of Chart 1). Another reliable leading growth indicator, the level of high-yield corporate bond spreads, is also signaling a rebound in both the U.S. and euro area economies over the next few quarters (Chart 9). Chart 9High-Yield Spreads Are A Leading Economic Indicator Global bond yields, meanwhile, seem stuck between a rock and a hard place. As shown in Chart 10, yields move with expectations of future growth. Bond investors are sensitive to declines in expectations of future growth, captured by the global LEI, as this necessitates central bank intervention in the future to lower short-term rates, thus bringing down the expectations component of long-term yields. At the same time, a slowdown in growth in the present increases the safe-haven demand for bonds which again drives down yields. Chart 10Potential Triggers For Higher Bond Yields   Although the global is ticking back up, global policy uncertainty (Chart 10, middle panel) is near all-time highs due to the U.S.-China trade war. In such an environment, investors will naturally flock to the safety of bonds. In previous reports, we have shown how similar the current backdrop is to the 2015/2016 episode, when nervous bond investors were less likely to be forward-looking and needed to see firm evidence of a pickup in global growth before they started to push up yields on a sustained basis. Given the increasing likelihood that global central banks will not be able to fully deliver the amount of aggressive easing discounted by markets because of a more stable growth backdrop, any lessening of trade tensions – a growing possibility with U.S. President Donald Trump gearing up for the 2020 election – should allow calmer heads to once again prevail as global economic momentum improves and policy uncertainty wanes. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. It remains to be seen how policymakers respond to that outcome. Given recent history, however, we fear that central bankers could end up turning more hawkish once again faster than markets expect, which would set the stage for a more sustainable rise in global bond yields in 2020. Bottom Line: We still recommend that investors stick to a neutral benchmark overall portfolio duration stance in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding. On a cyclical horizon, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields are likely to rise. As Trump reaches for a deal ahead of the 2020 election, the decline in global policy uncertainty will contribute to a more bond-bearish environment.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma, Research Associate shaktis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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