Policy

Dear Client, Instead of our regular report, this week we are sending you a Special Report penned by Matt Gertken, Chief Geopolitical Strategist of our sister Geopolitical Strategy service, titled “The Polybius Solution.” In this report Matt argues that a full-fledged cold war with China would put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights So What? U.S.-Iran risk is front-loaded, but U.S.-China is the greater risk overall. A full-fledged cold war with China will put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. War with Iran or trade war escalation with China are both ultimately dollar bullish – even though tactically the dollar may fall.  Feature The idea of the “Thucydides Trap” has gone viral in recent years – for good reason. The term, coined by Harvard political scientist Graham Allison, refers to the ancient Greek historian Thucydides (460-400 BC), author of the seminal History of the Peloponnesian War. The “trap” is the armed conflict that most often develops when a dominant nation that presides over a particular world order (e.g. Sparta, the U.S.) faces a young and ambitious rival that seeks fundamental change to that order (e.g. Athens, China).1 This conflict between an “established” and “revisionist” power was highlighted by the political philosopher Thomas Hobbes in his translation of Thucydides in the seventeenth century; every student of international relations knows it. Allison’s contribution is the comparative analysis of various Thucydides-esque episodes in the modern era to show how today’s U.S.-China rivalry fits the pattern. The implication is that war (not merely trade war) is a major risk. We have long held a similar assessment of the U.S.-China conflict. It is substantiated by hard data showing that China is gaining on America in various dimensions of power (Chart 1). Assuming that the U.S. does not want to be replaced, the current trade conflict will metastasize to other areas. If the U.S. and China really engage in an epic conflict, American political polarization should fall. There is an important but overlooked corollary to the Thucydides Trap: if the U.S. and China really engage in an epic conflict, American political polarization should fall. Polarization fell dramatically during the Great Depression and World War II and remained subdued throughout the Cold War. It only began to rise again when the Soviet threat faded and income inequality spiked circa 1980. Americans were less divided when they shared a common enemy that posed an existential threat; they grew more divided when their triumph proved to benefit some disproportionately to others (Chart 2). Chart 1China Is Gaining On The U.S. China Is Gaining On The U.S. China Is Gaining On The U.S. Chart 2U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis   If the U.S. and China continue down the path of confrontation, a similar pattern is likely to emerge in the coming years – polarization is likely to decline. China possesses the raw ability to rival or even supplant the United States as the premier superpower over the very long run. Its mixed economy is more sustainable than the Soviet command economy was, and it is highly integrated into the global system, unlike the isolated Soviet bloc. As long as China’s domestic demand holds up and Beijing does not suppress its own country’s technological and military ambitions, Trump and the next president will face a persistent need to respond with measures to limit or restrict China’s capabilities. Eventually this will involve mobilizing public opinion more actively. Further, if the U.S.-China conflict escalates, it will clarify U.S. relations with the rest of the world. For instance, Trump’s handling of trade suggests that he could refrain from trade wars with American allies to concentrate attention on China, particularly sanctions on its technology companies. Meanwhile a future Democratic president would preserve some of these technological tactics while reinstituting the multilateral approach of the Barack Obama administration, which launched the “Pivot to Asia,” the Trans-Pacific Partnership, and intensive freedom of navigation operations in the South China Sea. These are all aspects of a containment strategy that would reinforce China’s rejection of the western order. Bottom Line: If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective. So far these things have not occurred, but they are logical corollaries of the Thucydides Trap and they will occur if the Thucydides thesis is validated. How Would China Fare In The Thucydides Trap? China would be in trouble in this scenario. The United States, if the public unifies, would have a greater geopolitical impact than it currently does in its divided state. And a western alliance would command still greater coercive power than the United States acting alone (Chart 3). External pressure would also exacerbate China’s internal imbalances – excessive leverage, pollution, inefficient state involvement in the economy, poor quality of life, and poor governance (Chart 4). China has managed to stave off these problems so far because it has operated under relative American and western toleration of its violations of global norms (e.g. a closed financial system, state backing of national champions, arbitrary law, censorship). This would change under concerted American, European, and Japanese efforts. Chart 3China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' Chart 4China's Domestic Risks Underrated China's Domestic Risks Underrated China's Domestic Risks Underrated Concerted external pressure would make it harder for China to manage its internal imbalances. How would the Communist Party respond? First, it could launch long-delayed and badly needed structural reforms and parlay these as concessions to the West. The ramifications would be negative for Chinese growth on a cyclical basis but positive on a structural basis since the reforms would lift productivity over the long run – a dynamic that our Emerging Markets Strategy has illustrated, in a macroeconomic context, in Diagram 1. This is already an option in the current trade war, but China has not yet clearly chosen it – likely because of the danger that the U.S. would exploit the slowdown. Diagram 1Foreign Pressure And Structural Reform = Short-Term Pain For Long-Term Gain The Polybius Solution The Polybius Solution Alternatively the Communist Party could double down on confrontation with the West, as Russia has done. This would strengthen the party’s grip but would be negative for growth on both a cyclical and structural basis. The effectiveness of China’s fiscal-and-credit stimulus would likely decline because of a drop in private sector activity and sentiment – already a nascent tendency – while the lack of “reform and opening up” would reduce long-term growth potential. This option makes structural reforms look more palatable – but again, China has not yet been forced to make this choice. None of the above is to say that the West is destined to win a cold war with China, but rather that the burden of revolutionizing the global order necessarily falls on the country attempting to revolutionize it. Bottom Line: If the Thucydides Trap fully takes effect, western pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy. This is where the risk of armed conflict rises. Introducing … The Polybius Solution The problem with the above is that there is no sign of polarization abating anytime soon in the United States. Extreme partisanship makes this plain (Chart 5). Rising polarization could prevent the U.S. from responding coherently to China. The Thucydides Trap could be avoided, or delayed, simply because the U.S. is distracted elsewhere. The most likely candidate is Iran. Chart 5 A lesser known Greek historian – who was arguably more influential than Thucydides – helps to illustrate this alternative vision for the future. This is Polybius (208-125 BC), a Greek who wrote under Roman rule. He described the rise of the Roman Empire as a result of Rome’s superior constitutional system. Polybius explains domestic polarization whereas Thucydides explains international conflict. Polybius took the traditional view that there were three primary virtues or powers governing human society: the One (the king), the Few (the nobles), and the Many (the commons). These powers normally ran the country one at a time: a dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator. His singular insight – his “solution” to political decay – was that if a mixture or balance of the three powers could be maintained, as in the Roman republic, then the natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers (Diagram 2). Diagram 2Polybius: A Balanced Political System Breaks The Natural Cycle Of Tyranny And Chaos The Polybius Solution The Polybius Solution In short, just as post-WWII economic institutions have enabled countries to reduce the frequency and intensity of recessions (Chart 6), so Polybius believed that political institutions could reduce the frequency and intensity of revolutions. Eventually all governments would decay and collapse, but a domestic system of checks and balances could delay the inevitable. Needless to say, Polybius was hugely influential on English and French constitutional thinkers and the founders of the American republic. Chart 6Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute What is the cause of constitutional decay, according to Polybius? Wealth, inequality, and corruption, which always follow from stable and prosperous times. “Avarice and unscrupulous money-making” drive the masses to encroach upon the elite and demand a greater share of the wealth. The result is a vicious cycle of conflict between the commons and the nobles until either the constitutional system is restored or a democratic revolution occurs. Compared to Thucydides, Polybius had less to say about the international balance of power. Domestic balance was his “solution” to unpredictable outside events. However, states with decaying political systems were off-balance and more likely to be conquered, or to overreach in trying to conquer others. Bottom Line: The “Polybius solution” equates with domestic political balance. Balanced states do not allow the nation’s leader, the elite, or the general population to become excessively powerful. But even the most balanced states will eventually decline. As they accumulate wealth, inequality and corruption emerge and cause conflict among the three powers. Why Polybius Matters Today It does not take a stretch of the imagination to apply the Polybius model to the United States today. Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits – and this is true even without any historic crisis event to justify it. U.S. polarization is contaminating foreign policy. The rise in polarization has coincided with a rise in wealth inequality, much as Polybius would expect (Chart 7). In all likelihood the Trump tax cuts will exacerbate both of these trends (Chart 8). Even worse, any attempts by “the people” to take more wealth from the “nobles” will worsen polarization first, long before any improvements in equality translate to a drop in polarization. Chart 7Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Chart 8Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Most importantly, from a global point of view, U.S. polarization is contaminating foreign policy. Just as the George W. Bush administration launched a preemptive war in Iraq, destabilizing the region, so the Obama administration precipitously withdrew from Iraq, destabilizing the region. And just as the Obama administration initiated a hurried détente with Iran in order to leave Iraq, the Trump administration precipitously withdrew from this détente, provoking a new conflict with Iran and potentially destabilizing Iraq. Major foreign policy initiatives have been conducted, and revoked, on a partisan basis under three administrations. And a Democratic victory in 2020 would result in a reversal of Trump’s initiatives. In the meantime Trump’s policy could easily entangle him in armed conflict with Iran – as nearly occurred on June 21. Iranian domestic politics make it very difficult, if not impossible, to go back to the 2015 setting. Despite Trump’s recent backpedaling, his administration runs a high risk of getting sucked into another Middle Eastern quagmire as long as it enforces the sanctions on Iranian oil stringently. China would be the big winner if such a war occurred, just as it was one of the greatest beneficiaries of the long American distraction in Afghanistan and Iraq. It would benefit from another 5-10 years of American losses of blood and treasure. It would be able to pursue regional interests with less Interference and could trade limited cooperation with the U.S. on Iran for larger concessions elsewhere. And a nuclear-armed Iran – which is a long-term concern for the U.S. – is not in China’s national interest anyway. Bottom Line: The U.S. is missing the “Polybius solution” of balanced government; polarization is on the rise. As a result, the grand strategy of “pivoting to Asia” could go into reverse (Chart 9). If that occurs, the conflict with China will be postponed or ineffective. Chart 9Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Iran Is The Wild Card If the U.S. gets bogged down in the Middle East yet again, the “Pivot To Asia” will go into reverse and the “Thucydides Trap” with China will be delayed. A war with Iran manifestly runs afoul of the Trump administration’s and America’s national interests, whereas a trade war with China does not. First, although an Iranian or Iranian-backed attack on American troops would give Trump initial support in conducting air strikes, the consequences of war would likely be an oil price shock that would sink his approval rating over time and reduce his chances of reelection (Chart 10). We have shown that such a shock could come from sabotage in Iraq as well as from attacks on shipping in the Strait of Hormuz. Iran could be driven to attack if it believes the U.S. is about to attack. Second, not only would Democrats oppose a war with Iran, but Americans in general are war-weary, especially with regard to the Middle East (Chart 11). President Trump capitalized on this sentiment during his election campaign, especially in relation to Secretary Hillary Clinton who supported the war in Iraq. Over the past two weeks, he has downplayed the Iranian-backed tanker attacks, emphasized that he does not want war, and has ruled out “boots on the ground.” Chart 10Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Chart 11 Third, it follows from the above that, in the event of war, the United States would lack the political will necessary to achieve its core strategic objectives, such as eliminating Iran’s nuclear program or its power projection capabilities. And these are nearly impossible to accomplish from the air alone. And U.S. strategic planners are well aware that conflict with Iran will exact an opportunity cost by helping Russia and China consolidate spheres of influence. The wild card is Iran. President Hassan Rouhani has an incentive to look tough and push the limits, given that he was betrayed on the 2015 deal. And the regime itself is probably confident that it can survive American air strikes. American military strikes are still a serious constraint, but until the U.S. demonstrates that it is willing to go that far, Iran can test the boundaries. In doing so it also sends a message to its regional rivals – Saudi Arabia, the Gulf Arab monarchies, and Israel – that the U.S. is all bark, no bite, and thus unable to protect them from Iran. This may lead to a miscalculation that forces Trump to respond despite his inclinations. The China trade war, by contrast, is less difficult for the Trump administration to pursue. There is not a clear path from tariffs to economic recession, as with an oil shock: the U.S. economy has repeatedly shrugged off counter-tariffs and the Fed has been cowed. While Americans generally oppose the trade war, Trump’s base does not, and the health of the overall economy is far more important for most voters. And a majority of voters do believe that China’s trade practices are unfair. Strategic planners also favor confronting China – unlike Trump they are not concerned with reelection, but they recognize that China’s advantages grow over time, including in critical technologies. Bottom Line: While the media and market focus on China and Iran risks can alternate in the short run, the Trump administration is likely to continue downgrading the conflict with Iran and upgrading the conflict with China over the next six-to-18 months. Neither politics nor grand strategy support a war with Iran, whereas politics might support a trade war with China and grand strategy almost certainly does. China Could Learn From Polybius Too China also lacks the Polybius solution. It suffers from severe inequality and social immobility, just like the Latin American states and the U.S., U.K., and Italy (Chart 12). But unlike the developed markets, it lacks a robust constitutional system. Political risks are understated given the emergence of the middle class, systemic economic weaknesses, and poor governance. Over the long run, Xi Jinping will need to step down, but having removed the formal system for power transition, a succession crisis is likely. Chart 12 China’s imbalances could cause domestic instability even if the U.S. becomes distracted by conflict in the Middle East. But China has unique tools for alleviating crises and smoothing out its economic slowdown, so the absence of outside pressure will probably determine its ability to avoid a painful economic slump. China also lacks the “Polybius solution” of balanced government – and it even lacks a robust constitutional system. This helps to explain China’s interest in dealing with the U.S. on North Korea. President Xi Jinping’s first trip to Pyongyang late last month helped pave the way for President Trump to resume negotiations with the North’s leader Kim Jong Un at the first-ever visit of an American president north of the demilitarized zone (DMZ). China does not want an unbridled nuclear North Korea or an American preventative war on the peninsula. If Beijing could do a short-term deal with the U.S. on the basis of assistance in reining in North Korea’s nuclear and missile programs, it could divert U.S. animus away from itself and encourage the U.S. to turn its attention toward the next rogue nuclear aspirant, Iran. It would also avoid structural economic concessions. Of course, a smooth transition today means short-term gain but long-term pain for Chinese and global growth. Productivity and potential GDP will decline if China does not reform (Diagram 3). But this kind of transition is the regime’s preferred option since Beijing seeks to minimize immediate threats and maintain overall stability. Diagram 3Stimulus And Delayed Reforms = Socialist Put = Stagflation The Polybius Solution The Polybius Solution If Chinese internal divisions do flare up, China’s leaders will take a more aggressive posture toward its neighbors and the United States in order to divert public attention and stir up patriotic support. Bottom Line: China suffers from understated internal political risk. While U.S. political divisions could lead to a lack of coherent strategy toward China, a rift in China could lead to Chinese aggression in its neighborhood, accelerating the Thucydides Trap. Investment Conclusions If the U.S. reverses the pivot to Asia, attacks Iran, antagonizes European allies, and exhausts its resources in policy vacillation, its budget deficit will balloon (Chart 13), oil prices will rise, and China will be left to manage its economic transition without a western coalition against it. The implication is a weakening dollar, at least initially. But the U.S. is nearing the end of its longest-ever business expansion and an oil price spike would bring forward the next recession, both of which will push up the greenback. Much will depend on the extent of any oil shock – whether and how long the Strait of Hormuz is blocked. Beyond the next recession, the dollar could suffer severe consequences for the U.S.’s wild policies. Chart 13An Iran War Will Bust The Budget An Iran War Will Bust The Budget An Iran War Will Bust The Budget Persian Gulf risks are coming to the fore. But over the next six-to-18 months, U.S.-China conflict will be the dominant marketmover. If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Our highest conviction call on this matter is that any trade deal before the U.S. 2020 election will be limited in scope. It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Our trade war probabilities, updated on July 26, can be found in Diagram 4. The combined risk of further escalation is 60% -- meaning that the U.S. will either implement the final batch of tariffs or refuse to renew Huawei’s trade license, or both. We are maintaining our risk-off trades: long JPY/USD, long gold, long Swiss bonds, and long USD/CNY. Diagram 4U.S.-China Trade War Decision Tree (Updated July 26, 2019) The Polybius Solution The Polybius Solution   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Graham Allison, “The Thucydides Trap: Are The U.S. And China Headed For War?” The Atlantic, September 24, 2015, and Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Mifflin Harcourt, 2017).

Highlights A lot has changed in a week and a half, … : The FOMC meeting that we thought would mark the end of global market-moving news until September turned out to be a prelude for the real fireworks. … as U.S.-China trade tensions escalated, … : The imposition of tariffs on the only remaining subset of Chinese imports that had escaped duties so far inspired China to let the yuan fall below a key technical level. … and other countries braced for the fallout: China’s devaluation opened up a new front in the conflict, turning a bilateral tariff spat into a threat to other countries’ well-being and competitiveness. Asia-Pacific central banks swiftly followed with larger-than-expected rate cuts. Below-benchmark-duration positioning is no longer appropriate in the near term, and we recommend moving to benchmark duration: Interest rates will be hard-pressed to rise with global central banks squarely in easing mode. Although we still believe that inflation and the fed funds rate will surprise to the upside, it’s going to take a while. Feature Dear Client, There will be no U.S. Investment Strategy next week as we take our final summer break. U.S. Investment Strategy will return on Monday, August 26th. Best regards, Doug Peta So much for the idea that the July 30-31 FOMC meeting would be the last market-moving event before Labor Day. By lunchtime on August 1st, the S&P 500 was back to its July 30th close above 3,010; the 10-year Treasury yield had settled around 1.96%, ten basis points (“bps”) lower than its pre-meeting level; and gold had fallen by ten bucks, to $1,420, as markets digested the news that the Fed was less concerned about the economy than they were. Then the trade war reared its ugly head in the form of new tariffs on Chinese imports to the U.S., and the S&P slid to 2,822, the 10-year Treasury yield tumbled to 1.59%, and gold surged to $1,510. The new round would ensnare the subset of goods that had previously been spared from import duties, and Beijing promised to retaliate. It’s hard for rates to rise when every central bank has an easing bias as it nervously eyes the U.S.-China tilt.   Chart 1Beijing Plays The Currency Card Beijing Plays The Currency Card Beijing Plays The Currency Card The retaliation arrived Sunday night in the U.S., when Chinese officials allowed the renminbi to trade above 7 to the dollar for the first time since 2008 (Chart 1). The move provoked a global equity selloff, and the S&P 500 lost 3% in its worst session of the year. With the currency floodgates opened, the trade war morphed from a bilateral tariff spat into a global battle for competitiveness, and central banks in India, Thailand and New Zealand responded with larger-than-expected rate cuts. India is a comparatively closed economy battling a domestic downturn, but it is clear that countries with any reliance on exports are loath to be saddled with a strong currency that will hamstring their global competitiveness. It turns out that the Fed isn’t the only central bank that sees the appeal of taking out some insurance. That is an unfriendly backdrop for below-benchmark-duration positioning, and we are joining our fixed-income colleagues in raising our duration recommendation from underweight to neutral over the tactical timeframe (0-3 months). While we still believe that the fed funds rate and long yields will surprise to the upside, they cannot do so while bond investors are adamant that the Fed is going to have to adopt an easing bias over the near term. Our rates checklist, discussed in the rest of this report, supports the decision. The shift in the rates backdrop undermines our newly established agency mortgage REIT recommendation, and we are watching it closely. The Rates Checklist: The Fed Table 1Rates View Checklist When The Facts Change When The Facts Change Turning to our rates view checklist (Table 1), the first item is derived from our U.S. Bond Strategy service’s golden rule of bond investing.1 The golden rule asks one simple question to anchor views on Treasuries: Over the next 12 months, will the Fed move the fed funds rate by more or less than the bond market is currently discounting? Since 1990, when the Fed has surprised dovishly (the fed funds rate has turned out to be lower than the money market implied twelve months earlier), Treasuries have almost always generated positive excess returns over cash. Periods of negative excess returns have occurred nearly exclusively when the Fed has delivered a hawkish surprise. We still think inflation will become a problem, but it certainly isn’t one yet. Since we rolled out the checklist last year, we have consistently expected a hawkish surprise. Though we continue to believe that an extended cycle of rate cuts is not in the cards, markets disagree, and we concede that the Fed now has a near-term easing bias, despite Chair Powell’s demurrals at the post-meeting press conference. We are leaving the box unchecked because we believe that nearly four more 25-bps cuts over the next twelve months, equating to a target fed funds rate of 1.25-1.50% (Chart 2), are unlikely. The spread between our expectations and the market’s expectations is still wide enough to merit a below-benchmark-duration view over the next twelve months, even if benchmark duration makes more sense for the rest of the year. Chart 2Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch The yield curve’s inversion has become more pronounced in the wake of the re-escalation of the trade war (Chart 3), and we duly check the second box. As a reminder, we track the 3-month/10-year segment of the yield curve to define inversion because it is less susceptible to estimate error, and has been a timelier indicator of recessions, than the more frequently cited 2-year/10-year segment. We have argued before that the unprecedentedly large negative 10-year term premium makes the curve more prone to invert and makes it a less sensitive economic barometer, but part of the rationale of creating a checklist is to limit one’s discretion in interpreting events. Chart 3More Rate Cuts, Please More Rate Cuts, Please More Rate Cuts, Please The Rates Checklist: Inflation Inflation has gone AWOL around the globe. Although the U.S. no longer faces the negative output gaps that remain in other major economies, its main measures of consumer prices (Chart 4) do nothing to counteract the widespread view that the Fed has a free pass to devote its energies to shoring up growth. Inflation break-evens were making progress toward the 2.3-2.5% range consistent with the Fed’s 2% inflation target when we launched the checklist last year, but the plunge in oil prices stopped them in their tracks (Chart 5). Rather than encouraging the Fed to hike, soft inflation expectations helped drive the Fed’s dovish pivot. Chart 4Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Chart 5... And So Are Inflation Expectations ... And So Are Inflation Expectations ... And So Are Inflation Expectations Our view that the seeds of inflation pressures have been sown has not changed. After slowing on a real final domestic demand basis in the first quarter from the one-two punch of the government shutdown and the fourth quarter’s sharp tightening of financial conditions, the U.S. economy has resumed operating above capacity. Though we check the “sluggish-inflation” boxes, and acknowledge that inflation is not going to inspire a more restrictive turn in Fed policy any time soon, we do think it will become an issue down the road. The Rates Checklist: The Labor Market The labor market remains robust. The headline unemployment rate remains at a level last seen in 1969, and is well below the CBO’s estimate of NAIRU. NAIRU is the minimum structural unemployment rate, and wage gains quicken when the unemployment rate falls below it (Chart 6). The broader definition of unemployment, encompassing discouraged workers and involuntary part-time workers, fell to its lowest level since 2000 in July (Chart 7), and the job openings and job quits rates (Chart 8) indicate that demand for workers remains high. Chart 6Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Chart 7... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust ... And Demand Is Robust ... And Demand Is Robust Chart 9   3.2% year-over-year growth in average hourly earnings may not be thrilling, but wages do remain in an uptrend. The laws of supply and demand (Chart 9), and the Fed’s best efforts, suggest that the uptrend will continue. We do not check any of the labor market boxes, and expect that we will not over the rest of the year. The Rates Checklist: Instability At Home And Abroad Chart 10No Overheating Yet No Overheating Yet No Overheating Yet There continue to be no signs of cyclical overheating in the U.S. economy, as the most cyclical segments of the economy are nowhere near the red end of the tachometer (Chart 10). Financial imbalances have moved to the back burner, but they are part of the Fed’s post-crisis mandate, and we are leaving the imbalances box unticked to reflect that the “low spreads and loosening credit terms” Governor Brainard decried last September2 may stay the Fed from embarking on a full-on easing cycle. We are checking the international duress box, at least for the time being, given the potential for a self-reinforcing rate-cutting cycle that could hold down the entire term structure of rates around the world. Bottom Line: The inverted yield curve, a lack of consumer price inflation, and the cloud cast by the trade war all suggest that bond markets will require some convincing before they allow rates to rise much higher. We conclude that a neutral duration stance is appropriate in the near term. Keeping Score We have been staunch supporters of below-benchmark duration positioning since the end of last July,3 given that we thought the 10-year Treasury yield was too low relative to our assessment of the strength of the U.S. economy and the potential for inflation to begin to rise. It appears that our stronger-than-consensus economic view was correct, but we were myopic in failing to grasp how punk growth in the rest of the world would keep long-maturity Treasury yields from making a sustained move higher. We were way early on inflation’s ETA, and slow to grasp how sensitive the Fed would be to faltering global growth and escalating trade tensions in its absence. In short, both our model of the Fed’s reaction function and the inputs to our model turned out to be faulty. The duration call stings, but our asset allocation recommendations have worked out. The fix we are making is to wait until inflation is a clear and present danger before assuming that the Fed will respond to it. Although we got the duration call wrong, investment-grade and high-yield corporate bonds have outperformed Treasuries in the aggregate since we upgraded them to overweight versus Treasuries at the end of January (Chart 11). BCA as a house niftily sidestepped the fourth-quarter selloff in equities by downgrading them to equal weight, and raising cash to overweight, late last June. We upgraded equities to overweight versus cash and fixed income in our first publication of the year, and the S&P 500 has handily outperformed Treasuries since that date, despite the nasty selloff following the July FOMC meeting and the new round of tariffs (Chart 12). Chart 11Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Chart 12... But Equities Have Crushed Them ... But Equities Have Crushed Them ... But Equities Have Crushed Them Agency Mortgage REIT Implications We recommended agency mortgage REITs a day before the FOMC meeting, suggesting that investors allocate capital away from equities and high yield as a way to reduce equity beta and boost portfolio income away from the herd chasing lower and lower high-yield bond yields. Through Thursday’s close, the Bloomberg Mortgage REIT Index has gained about 35 bps on a total return basis, while the Barclays High Yield Index is off 70 bps and the S&P 500 is down 2.7%. Unfortunately, the agency mREITs we sought out for their yield curve exposure have lagged badly as the yield curve has relentlessly flattened. For now, only the one agency mREIT with a dedicated adjustable-rate mortgage portfolio faces immediate earnings pressure. The rest are subject to refinancing volumes, which are likely to be higher than we expected when we projected that the 10-year Treasury yield wouldn’t fall much below 2%. The specter of increased prepayments makes the agency mREITs a less attractive investment than we thought they would be two weeks ago. On the other hand, their exclusively domestic exposure, and low credit risk, increases their value as a haven from global turmoil. Net-net, we are sticking with them, though they are now on a far shorter leash than they were when we made the recommendation. We will not stick with a position to save face, or to avoid looking irresolute. Flexibility and a willingness to admit mistakes are essential characteristics of successful investors. When the facts change, we change our mind, without the faintest hint of embarrassment. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 24, 2018 U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” available at usbs.bcaresearch.com. 2 Brainard, Lael (2018). “What Do We Mean by Neutral And What Role Does It Play in Monetary Policy,” speech delivered at the Detroit Economic Club, Detroit, Mich., September 12, 2018. 3 Please see the July 30, 2018 U.S. Investment Strategy Weekly Report, “The Rates Outlook,” available at usis.bcaresearch.com.

Highlights A unified push among central banks to drop their currencies inevitably leads to lower interest rates, which eventually sows the seeds of a recovery. However, with prospects of a full-blown trade war in front view, fundamentals could be put to the wayside for longer, as markets keep the switch on risk aversion. The new round of tariffs could pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops. The breakdown in the AUD/JPY cross is precarious. Stay short USD/JPY, but focus on the crosses rather than on outright bets versus the dollar. The RBNZ’s dovish surprise was a positive catalyst for our AUD/NZD and SEK/NZD positions. Remain long. Feature Chart I-1Summer Blues Summer Blues Summer Blues Just as summer trading volumes are falling close to new lows, central banks appear to be weaponizing their exchange rates in a renewed currency war salvo. Both the Reserve Bank of India (RBI) and the Reserve Bank of New Zealand (RBNZ) surprised market participants this week by slashing rates by more than expected. In retrospect, the European Central Bank probably fired the first shot at its forum in Sintra, Portugal this June. ECB President Mario Draghi highlighted back then that if the inflation outlook failed to improve, the central bank had considerable headroom to launch a fresh expansion of its balance sheet. What has followed is a renewed wave of dovishness by global central banks, which should intensify, given the latest flare-up in the trade war. For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets keep the switch on risk aversion (Chart I-1). This is because there is little visibility on either the political or the economic front. Our strategy remains three-fold: First, maintain tight stops on tactical positions. Second, we prefer trades at the crosses rather than versus the dollar, for now. Finally, maintain portfolio insurance by being short the USD/JPY. USD/CNY And The Economics Of Tariffs Chart I-2Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Standard theory suggests that exchange rates should move to equalize prices across any two countries. The question that naturally follows is by how much? The answer is that the exchange rate should move by exactly the same percentage point as the price change, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. All demand will flow to one country, until its currency rises by enough to equalize prices across borders again. However, assume countries ‘A’ and ‘B’ produce heterogeneous goods (‘A’ being the U.S. in this case, and ‘B’ China). Then the loss of purchasing power in Country ‘A’ will lead to less demand for Country ‘B’’s goods. The former loses purchasing power because prices of imports have increased by the amount of the tariff. This means the latter’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, if there are no other outlets to liquidate Country ‘B’’s goods. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less than, in percentage point terms, to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs, and many other factors that influence tradeable prices, the currency adjustment needed should be smaller. Since the onset of 2018, the U.S. has slapped various tariffs on China, the latest of which is 10% on $300 billion worth of Chinese goods. The U.S. currently imports $509 billion worth of goods from China, about 16% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.4% (Chart I-2). This suggests that at best, a 25% tariff on all Chinese imports will only lift import prices by 4% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 18.4% of total exports, a ratio that has been falling since 2018. Therefore, a tariff of 25% should only lift export prices by 4.5%. The conclusion is that the yuan and the dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing. This brings us to an important point: Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing (Table I-1). The DXY index is up 10% since its 2018 trough, while the USD/CNY has risen by 12%. This is much more than economic theory would suggest. In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.1 But if past is prologue, the new round of tariffs will pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops – mainly a slowing global economy and a slowing Chinese economy. Chart I- With no corresponding export subsidy for U.S. goods, however, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this will make a meaningful dent in corporate profits. This is an important political impediment. Historically, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. A Disorderly Breakdown Or Steady Depreciation? The RMB has been trading like a pro-cyclical currency, meaning it is becoming an important signaling mechanism for the evolution of the cycle. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-3). It has also closely mirrored the broad trade-weighted dollar (Chart I-4). This has implications for developed market currencies, especially those tied to Chinese demand. Therefore, it will be important to see if the RMB has a disorderly breakdown towards 7.4 or if it stabilizes at higher levels. A few barometers will be key to watch: Chart I-3The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical Chart I-4Is The Dollar Headed Higher? Is The Dollar Headed Higher? Is The Dollar Headed Higher? In a world of rapidly falling yields, Chinese rates remain attractive. Historically, USD/CNY has moved in line with interest rate differentials between the U.S. and China. The current divergence is unsustainable (Chart I-5). Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, not much depreciation is being priced in (Chart I-6). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. Chart I-5The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive Chart I-6Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Chinese money and credit growth, especially forward-looking liquidity indicators such as M2 relative to GDP, have bottomed. Historically, this led the cycle by a few months. The drop in Chinese bond yields is also reflationary, and should soon stimulate imports, especially if the improvement in exports continues (Chart I-7). Chinese government expenditures are likely to inflect higher, especially given acute weakness in the July manufacturing data. Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-8). In addition, the recent VAT cuts for manufacturing firms, a cut to social security contributions, and a pickup in infrastructure spending are all net positives. Chart I-7Trade War Extends Traditional Lags Trade War Extends Traditional Lags Trade War Extends Traditional Lags Chart I-8Government Spending Set To Increase Government Spending Set To Increase Government Spending Set To Increase The housing market remains healthy. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China remain firm relative to the overall index. If house prices roll over, this will be a negative development (Chart I-9). The housing market remains healthy. A revival in the property market will support construction activity and investment. If house prices roll over, this will be a negative development. In terms of market dynamics, the AUD/JPY cross breached the important technical level of 72 cents, but has since recovered. This is important, since the cross failed to break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. It will be especially important to see a clear breach to signal we are entering a deflationary bust (Chart I-10). Chart I-9China Housing Is Fine China Housing Is Fine China Housing Is Fine Chart I-10AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious Bottom Line: We are watching a few key reflationary indicators to gauge whether it pays to be contrarian. The message is that it is not time yet, given the ramp-up in the trade war rhetoric.  Notes On The RBNZ Chart I-11AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap This week, the RBNZ surprised markets by cutting interest rates by 50 basis points to parity (expectations were for a 25-basis-point cut). From an external standpoint, this makes sense. Australia and China are New Zealand’s biggest trading partners, and have been easing policy much earlier. The RBNZ’s bet was that demand was probably going to recover by now. The latest salvo in the trade war probably dashed those hopes. Meanwhile, over the last 35 years, the AUD/NZD cross has spent more than 95% of the time over 1.06. With the AUD/NZD near record lows, the cross is cheap on a real effective exchange rate basis (meaning NZD is expensive) (Chart I-11).  This suggests that even though interest rates are aligning in both Australia and New Zealand, the Aussie should be 11% higher relative to the Kiwi because of the valuation starting point (Chart I-12). The market remains more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. Economic data in New Zealand are now converging to the downside relative to Australia (Chart I-13). Chart I-12Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Chart I-13New Zealand Has More Economic Downside New Zealand Has More Economic Downside New Zealand Has More Economic Downside The RBNZ began a new mandate on April 1st to include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Business confidence is rapidly falling, and employment will soon follow suit (Chart I-14). Meanwhile, for an economy driven by agricultural exports, productivity gains will be hard to come by. Economic data in New Zealand are now converging to the downside relative to Australia. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock which, at the moment, is turning in favor of the Aussie (Chart I-15). Iron ore prices may face further downside, given that supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Since eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie will get a boost. Chart I-14Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Chart I-15Terms Of Trade Favors##br## Aussie Terms Of Trade Favors Aussie Terms Of Trade Favors Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Housekeeping The stop on our short XAU/JPY position was triggered at 158,000 with a loss of -3.27%. This was a mean-reversion trade between two safe-havens, likely to work even if volatility remains elevated. Put it back on. Finally, lift the limit sell on EUR/GBP to 0.95.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: Labor market remains tight: Unemployment rate was steady at 3.7%; Participation rate increased to 63%; Average hourly earnings increased by 3.2% year-on-year; Nonfarm payrolls increased by 164 thousand. Initial jobless claims fell to 209 thousand last week. Trade balance narrowed slightly to $55.2 billion in June. Michigan sentiment index was unchanged at 98.4 in July. Markit composite and services PMI both increased to 52.6 and 53 respectively in July, while ISM non-manufacturing PMI fell to 53.7 in July. DXY index fell by 1% this week, erasing the gains following the Fed’s hawkish surprise last week. Weakness in the dollar given a ramp-up in trade war rhetoric suggest that dollar tailwinds are facing diminishing marginal returns. A few of our favorite dollar indicators, including the bond-to-gold ratio, are sending a warning signal. Report Links: Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have continued to deteriorate: Producer price inflation fell to 0.7% year-on-year in June. Retail sales increased by 2.6% year-on-year in June, surprising to the upside. Markit composite PMI was unchanged at 51.5 in July, while services PMI fell slightly to 53.2. Sentix investor confidence fell further to -13.7 in August, the lowest since 2014. EUR/USD increased by 1% this week. In the most recent Economic Bulletin, the ECB highlighted the risk of a weaker Q2 global services PMI which might lead to a more broad-based deterioration in global growth. With negative interest rates and diminishing marginal returns to monetary policy, the euro area will be ever dependent on fiscal stimulus. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Composite PMI was unchanged at 51.2 in July, while services PMI fell to 51.8. Household spending yearly growth fell to 2.7% in June. That said, previous growth of 4% was too high relative to Japan’s potential. Wages increased by 0.4% year-on-year in June. Leading economic index and coincident index both fell to 93.3 and 100.4 respectively in June. The trade balance increased to ¥759.3 billion in June. Current account balance narrowed to ¥1,211 billion in June. USD/JPY fell by 0.9% this week. In the Summary of Opinions released this week, the BoJ concluded that the Japanese economy has been moderately expanding, a trend that is likely to continue in the second half. However, this may be too ambitious. As we go to press, Q2 GDP growth is still pending, and a marked slowdown could be a harbinger for a much softer second half, especially given renewed trade tensions. That said, the path to easier monetary policy will be lined by a stronger yen. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: Markit composite PMI increased to 50.7 in July. Services and construction components also increased to 51.4 and 45.3 respectively. Retail sales increased by 0.1% year-on-year in July. Halifax house prices contracted by 0.2% month-on-month in July. GBP/USD has been very volatile but returned flat this week. All eyes are on the new PM Boris Johnson and new Brexit developments. Our Geopolitical strategist is assigning 21% risk of a no-deal Brexit, and the probability would rise to 30% if negotiations with the EU fail. We believe that the pound could easily drop to 1.10-1.15 if there is no deal. That being said, we are looking to sell EUR/GBP at 0.94, given Europe will also absorb some collateral damage from a hard Brexit. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: Producer price inflation increased to 2% year-on-year in Q2. Retail sales grew by 0.4% month-on-month in June. Both composite and services PMI increased to 52.1 and 52.3 respectively in July. Australian Industry Group (AiG) construction index fell to 39.1 in July. Exports grew by 1% month-on-month in June, while imports contracted by 4% month-on-month. This nudged the trade surplus to A$8 billion in June, a record. AUD/USD fell by 1.8% initially, then rebounded, returning flat this week. The RBA held interest rates unchanged at 1% on Tuesday, after cutting by 25 bps both in June and July. Long-term government bond yields declined to record-lows. Currency markets are currently focused on interest rate differentials. Once the focus shifts to other fundamentals as global interest rates converge, the Aussie dollar will get a boost. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: Consumer confidence decreased by 5.1% month-on-month in July. On the labor market front, the participation rate was steady at 70.4% in Q2; Unemployment rate fell to 3.9%; Wages increased by 2.2% year-on-year in Q2. NZD/USD fell by 0.8% this week. RBNZ shocked the market with the half-percentage point rate cut this Wednesday, stating that a larger initial move would be best to meet the inflation and employment objectives in New Zealand. The RBNZ also lowered 2-year inflation expectations from 2.01% to 1.86% in Q3. Relative terms-of-trade favors our long AUD/NZD position. Stay with it. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: Imports and exports both fell to C$50.2 billion and C$50.3 billion in June. The trade balance thus narrowed to C$0.14 billion. Bloomberg Nanos confidence index increased to 58.6 last week. Ivey PMI increased to 54.2 in July. New housing price index contracted by 0.2% year-on-year in June. USD/CAD increased by 0.2% this week. The sudden oil prices drop has dragged down the Canadian dollar. WTI crude oil prices plunged by more than 10% during the past week, and Western Canadian Select crude oil spot prices fell by 14.5%. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline and core consumer price inflation dropped to 0.3% and 0.4% year-on-year respectively in July. Manufacturing PMI fell to 44.7 in July. Consumer confidence fell to -8 in July. Real retail sales increased by 0.7% year-on-year in June. USD/CHF fell by 1.2% this week. The concerns over the global growth, an escalating trade war, a potential hard-Brexit, political tensions in the Middle East and East Asia continue to weigh on investors’ sentiment. VIX once again touched 24 following Trump’s tweet to threaten to impose 10% tariffs over $300 billion Chinese goods last Thursday. We continue to favor the safe-haven Swiss franc as a tactical portfolio hedge. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is little data from Norway this week: Manufacturing production yearly growth fell from 5% in May to 3% in June. USD/NOK has been flat this week.  Next week, the Norges Bank is likely to reverse its well-telegraphed forward guidance of rate hikes, following global developments. With oil prices down, and a new trade war, they will stand pat in line with market expectations, but an interest rate cut cannot be ruled out. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production contracted by 0.7% year-on-year in June. Services production yearly growth also fell to 1.3% in June. However, industrial orders increased by 7.5% year-on-year in June, the strongest since July 2018.  Budget balance widened to SEK 28.2 billion in July. USD/SEK fell by 0.9% this week. The upside surprise in industrial orders is mainly led by transport equipment. Mining and quarrying also rebounded to 9.3% compared with -7.8% in May. Our SEK/NZD position is now 0.4% in the money. The negative carry has been narrowed following RBNZ’s 50 bps rate cut. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! So Much For The Osaka G20 Tariff Ceasefire! So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down Key Risk-On/Risk-Off Indicators Breaking Down Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Where Is President Trump's Pain Threshold? Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Will Huawei Ban Hit The Tech Sectors? Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation China Sends Warning Via Currency Depreciation China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely The Yuan Will Fall, But Not Freely The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks The Rattling Of Sabers The Rattling Of Sabers Chart 7U.S. Allies' Share Of Treasuries Rises U.S. Allies' Share Of Treasuries Rises U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China Diversifies While It Depreciates China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Dollar Liquidity A Risk To Global Equities Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 So Much For Plaza Accord 2.0 So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord The Real Analogy With The Plaza Accord The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. Chart 12 While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Mainland Intervention In Hong Kong Could Prompt Sanctions Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade HK/Taiwan A Significant Share Of Greater China Trade HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). Chart 15 Chart 16 A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable U.S. Asian Allies Formidable U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level North Korean Provocations Still Low-Level North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia May Need To Distract From Domestic Unrest Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment A Strategic Investment A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.

Dear Client, In addition to this week’s Global Investment Strategy report, I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Best regards, Peter Berezin, Chief Global Strategist Highlights The trade war is likely to get worse before it gets better, implying some near-term downside risks to global equities and corporate credit. Nevertheless, both sides have a strong incentive to keep the conflict from spiraling out of control.  Unlike in the earlier rounds, consumer goods represent the bulk of the imports subject to tariffs in the latest round. Many of these Chinese imports also do not have readily-available foreign or domestic alternatives. If U.S. retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with – will sour further, hurting President Trump’s re-election prospects. Investors should overweight global equities over a 12-month horizon. We intend to upgrade EM and European stocks. However, we are waiting for the trade war to simmer down and global growth to revive before we do so. Feature Tariffied Last week, we wrote that “Risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated.”1 Stocks have been on a rollercoaster ride since then. S&P 500 futures were down almost 8% on Monday evening compared to last Thursday’s intraday highs before recovering much of their losses over the subsequent days (Chart 1). Chart 1 Needless to say, the brewing trade war between China and the U.S. remains foremost in investors’ minds. In what has become a familiar pattern of events, China moved quickly to retaliate against President Trump’s decision to raise tariffs on the remaining $300 billion of Chinese imports. The Chinese government announced that state-owned enterprises would suspend purchases of U.S. agricultural goods. The People’s Bank of China also allowed the USD/CNY exchange rate to move above 7, long regarded as a key psychological level. This prompted the U.S. Treasury to officially label China a “currency manipulator.” In and of itself, the decision to label China a currency manipulator means little. The designation was applied to China based on the loose criteria for manipulation used in the 1988 Omnibus Trade And Competitiveness Act, rather than under the more stringent criteria that the U.S. Treasury has employed since 2015 (the latest Treasury report issued in May, using this more stringent criteria, did not find China guilty of currency manipulation). The Treasury statement self-servingly said that Secretary Mnuchin “will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Given that the IMF indicated as late as three weeks ago that China’s “current account is broadly in line with fundamentals,” we doubt that much will come of this.2 Nevertheless, the designation further sours the atmosphere surrounding the trade talks, suggesting that the conflict will probably get worse before it gets better. Tough Luck, I Am Hitting Send The Chinese were apparently blindsided by President Trump’s decision to raise tariffs. According to media reports, Trump brushed off suggestions from his advisors during a tense Oval Office meeting last Thursday to notify the Chinese, as a courtesy, of the pending tariff announcement, choosing instead to send his tweet while everyone was still present in the room. (With Trump’s permission, Robert Lighthizer did try to place a phone call to Liu He, China’s Vice Premier and lead trade negotiator. The call went unanswered).3  Trump has reportedly become incensed that the Chinese, in his view, are stalling, secretly hoping that they will have a more conciliatory counterparty to deal with following next year’s presidential elections. From Trump’s perspective, a key goal of the tariffs is to make a strategy of running out the clock less appealing. Having successfully used the threat of tariffs to prompt Mexico to take stronger steps to curtail the flow of migrants to the U.S., Trump now feels emboldened to use strong-arm tactics to extract concessions from China. It’s a risky gambit. The Chinese will resist locking in any structural reforms that could weaken Beijing’s authority. The protests in Hong Kong have only added urgency for China’s leaders to look and act tough in the presence of what they describe as “foreign meddling.” All this means that a deal to prevent the latest tranche of tariffs from taking effect on September 1st is unlikely to be hatched. Mutually Assured Destruction? How bad could things get? The good news is that both sides have a strong incentive to keep the conflict from spiraling out of control. For the Chinese, it is not just a matter of losing access to the vast U.S. market. It’s also about losing access to vital technologies that China needs to further its ambitions in everything from robotics, to AI, to genomics. Chart 2Voters Are Not That Supportive Of Protectionism Voters Are Not That Supportive Of Protectionism Voters Are Not That Supportive Of Protectionism From Trump’s perspective, a severe trade war could hurt his re-election chances. Unlike late last year, the stock market’s recent plunge can be squarely attributed to the intensification of the trade war. If stocks keep falling, many voters with sagging 401(k) accounts will blame Trump. The initial rounds of U.S. tariffs focused on capital goods. In contrast, consumer goods represent the bulk of the imports subject to the latest tranche of duties. If retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with (Chart 2) – may sour further. It is also worth noting that Chinese goods account for a large fraction of overall imports in many of the categories subject to the latest round of tariffs. This will limit the ability of U.S. companies to source imports from other countries, thus putting further upward pressure on U.S. consumer prices. A Headwind, Not A Game Changer Neither the U.S. nor China would gain from a prolonged trade war. This does not mean that a “World War I” scenario, where all parties end up severely worse off from their actions, can be completely excluded. However, it does mean that powerful forces will probably kick in before the trade war gets out of hand. While global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. In such a “moderate” trade war scenario, where tariffs rise but the global supply chain continues to function, the asset market consequences are likely to be smaller than many observers believe. There are two reasons for this: First, there is the issue of magnitude. In value-added terms, U.S. exports of goods to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. represent 2.7% of Chinese GDP. These are not infinitesimal numbers, but even in the latter case, they are not particularly large either. Second, both the U.S. and China have some ability to offset the impact of a moderate trade war with stimulus. In the case of the U.S., the stimulus would come mainly in the form of more accommodative monetary policy. Indeed, since Jay Powell’s “hawkish” press conference last week, the 2-year yield has fallen by 24 basis points, while the 10-year yield has dipped by 29 basis points, largely because the market has priced in more rate cuts (Chart 3). In China’s case, the stimulus will continue to consist of credit-driven investment spending, with some tax cuts for consumers thrown in for good measure. Yes, China can stimulate its economy by further weakening its currency. However, such a strategy risks backfiring. As we saw in 2015-16, when China lost almost $1 trillion in reserves, even a small devaluation can foster expectations of a bigger one, leading to large-scale capital outflows (Chart 4). The fact that dollar-denominated debt has risen among China corporates further reduces the incentive to allow the yuan to weaken significantly. As such, we do not expect the Chinese to weaponize the yuan as a tool in the trade war. Chart 3U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts Chart 4China: A Devaluation Could Exacerbate Capital Outflows China: A Devaluation Could Exacerbate Capital Outflows China: A Devaluation Could Exacerbate Capital Outflows   Investment Conclusions As we discussed last week, the global manufacturing cycle tends to follow regular three-year periods – 18 months up, 18 months down (Chart 5). Given that the last downleg began in early 2018, we are due for another upturn in growth. The recent trade turbulence could delay the recovery for a bit, but ultimately, the manufacturing cycle will turn for the better. Central banks tend to be backward-looking. The weakness in both economic growth and inflation has prompted them to ease monetary policy. Just this week, central banks in Thailand, India, and New Zealand cut rates. The RBNZ shaved rates by 50 basis points, double what analysts were expecting. This brings to 16 the number of central banks which have lowered interest rates so far this year. Monetary policy affects the economy with a lag. Global growth is likely to start picking up just as the monetary stimulus is making its way through the system. Stocks will thrive in this environment. Thus, while global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. As global growth recovers, bond yields will rise. Investors should favor stocks over bonds. We do not have a strong view on regional equity allocation for now, but intend to upgrade EM and European stocks once the trade war simmers down and leading indicators for global growth start to march higher. Chart 5The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A One-Two Punch,” dated August 2, 2019. 2      Please see Gita Gopinath, “Rebalancing the Global Economy: Some Progress but Challenges Ahead,” IMF Blogs, July 17, 2019; and “2019 External Sector Report: The Dynamics of External Adjustment,” IMF External Sector Reports, July 2019. 3      Vivian Salama and Josh Zumbrun, “Trump Ordered New Chinese Tariffs Over Objections of Advisers,” The Wall Street Journal, August 7, 2019.  Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 6   Tactical Trades Strategic Recommendations Closed Trades

Feature Introduction Chart 1Japanese Equities: ##br##Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Clients have recently been asking us a lot about Japan. The reason seems clear. With the consistent outperformance of U.S. equities over the past decade, and their rather high valuations now, asset allocators are looking for an alternative. Emerging Markets and the euro zone have major structural concerns which suggest they are unlikely to outperform over any prolonged period (even if they might have a short-lived cyclical pop). Maybe Japan – whose own structural problems are well known and so surely priced in by now – could be a candidate for outperformance and a structural rerating over the next three to five years. Indeed, since the Global Financial Crisis (GFC), Japanese equities have not performed as badly as you might have imagined: they have performed in line with all their global peers – except for the U.S. (Chart 1). In this Special Report, we answer the most common questions that clients have asked us about the long-term (three to five year) outlook for Japan, and try to address the key issue: Are Japanese equities now a buying opportunity, or still a value trap? Our conclusions are as follows: The Japanese economy is still weighed down by structural problems – stubborn disinflation, and a shrinking and aging population – which means consumption growth will remain weak over the coming years. Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. We think it is unlikely, therefore, that Japanese equities will outperform in the long run. In that sense, Japan probably is a value trap, not a buying opportunity. In the past, Japanese equities benefited from bouts of Chinese reflationary stimulus – which we expect will be ramped up in the coming months – but the effect was usually short-lived and muted. The clash between accommodative monetary policy and contractionary fiscal policy, particularly October’s tax hike, is likely to dampen any revival in the Japanese economy. Global Asset Allocation downgraded Japanese equities to underweight over a six-to-12 month investment horizon in our most recent Quarterly Outlook.1 We find it hard to make a strong “rerating” case for Japan, and so, do not expect Japanese equities to outperform other major developed markets in the long run. Why Isn’t Inflation Rising? Chart 2Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation The market clearly does not believe that Bank of Japan (BoJ) Governor Haruhiko Kuroda can raise inflation to the BoJ’s target of 2%, despite negative interest rates and massive quantitative easing. The 5-year/5-year forward CPI swap rate, a proxy for inflation expectations, is currently at 0.1% (Chart 2, panel 1). Japan’s ultra-accommodative monetary policy has failed to push recorded inflation higher, with the core and core core measures2 both at 0.6% as of June (Chart 2, panel 2). In its recent outlook, the BoJ revised down its inflation forecasts in fiscal years 2019, 2020, and 2021 to 1.0%, 1.3%, and 1.6% respectively, implying that it does not expect to get even close to 2% over the forecast horizon.3  Prior to the bursting of Japan’s bubble in 1990, a big percentage of Japanese inflation came from domestic factors: housing, culture and recreation, and health care. By contrast, prices of items manufactured overseas, mainly in China, and imported goods – especially furniture and clothing – did not rise much. The same was true for other developed economies such as the U.S. and the euro area. However, since the 1990s, domestically-produced items in Japan have failed to rise in price, unlike the situation in the U.S. This kept a lid on Japanese inflation. Housing in particular, which represents about 20% of the inflation basket, now contributes only 0.02% to Japanese core core inflation (Chart 2, panels 3 & 4). Chart 3Deregulation = Low Inflation Deregulation = Low Inflation Deregulation = Low Inflation There are three main reasons for this difference: Stagnant wages Unfavorable demographics Deregulation The first two causes are discussed in detail below. Gradual deregulation of various industries has also been disinflationary. In the 1980s, Japan remained a highly regulated economy, with the government fixing many prices and limiting entry into many sectors. Although change has been slow, deregulation and the introduction of competition have caused structural downward pressure on prices in a number of industries, notably telecommunications and utilities. For example, deregulation of electric power companies in 2016 allowed increased competition and new entrants into the market.4 As a result, electricity prices in Japan dropped from an average of 11.4 JPY/Kwh prior to full deregulation to 9.3 JPY/Kwh (Chart 3). But there are still many industries which are more tightly regulated in Japan than in other advanced economies (the near-ban on car-sharing services such as Uber, and tight restrictions on AirBnB are just the most newsworthy examples). This suggests that structural disinflationary pressures are likely to persist on any further deregulation. Why Is Wage Growth Stagnant, Despite A Tight Labor Market? Chart 4Wages Have Been Beaten Down... bca.gaa_sr_2019_08_09_c4 bca.gaa_sr_2019_08_09_c4 Japan’s labor market appears very tight. The unemployment rate is 2.3%, the lowest since the early 1990s, and the jobs-to-applications ratio is 1.61, the highest since the 1970s. And yet wage growth has remained stagnant, averaging only 0.5% over the past five years. (Chart 4).5  There are a number of structural reasons why wages have failed to respond to the tight labor market situation. One major contributory factor is the social norm of “lifetime employment,” whereby many employees, especially at large companies, tend to stay with their initial employer through their careers, being rotated from one department to another, without becoming specialists in any particular field. This means they have little pricing power – and few transferable skills – when it comes to seeking a mid-career change. This social norm is also reflected in Japan’s typical salary schemes, which are based on employment length (Chart 5, panel 1). Wages tend to rise with age, while in other developed economies they peak around the age of 50. Another factor is the big increase in recent years in part-time and temporary positions, which typically pay lower wages than full-time positions. Because employment law makes it hard (if not impossible) to fire workers, companies have tended to prefer hiring non-permanent staff, who are easier to replace. Part-time workers have increased by 11 million over the past three decades, compared to an increase of two million in full-time workers (Chart 5, panel 2). A substantial part of this increase in part-time employment came from both the elderly and women joining the labor market – groups that have little wage bargaining power (Chart 5, panel 3). Part-time wage growth has also turned negative this year (Chart 5, panel 4). Bonuses are a significant portion of wages, and tend to be rather volatile, moving in line with corporate profits, which have weakened this year (Chart 5, panel 5). Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. Nonetheless, there are some tentative signs of a change in this social norm. The number of employees changing jobs has been rising over the past few years. This is mostly evident among employees aged over 45, signaling the need for experienced personnel (Chart 6, panel 1). The percentage of unemployed who had voluntarily quit their jobs, rather than being let go, has also reached an all-time high (Chart 6, panel 2). This evidence suggests that employees are increasingly willing to leave their jobs in search of a more interesting or a better-paid one. Given such a tight labor market, it seems only a matter of time before there is some pressure on employers to increase salaries in order to attract talent. Chart 5...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment Chart 6Changing The Norm Changing The Norm Changing The Norm   Is There An Answer To Japan’s Demographic Problem? Chart 7Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Deteriorating demographics is a key reason why inflation has remained subdued. The Japanese population peaked in 2009 and, over the past eight years, has shrunk on average by 0.2%, or 220,000 people, a year. Furthermore, the working-age population (25-64) has shrunk by 6 million, or 10%, since its peak in 2005. With marital rates continuing to fall, and fertility rates doing no more than stabilizing, there is no sign of a quick turnaround in this situation (Chart 7, panels 1 & 2). Prime Minister Abe has eased immigration laws to try to put a stop to the population decline. Late last year, the Diet passed a law that will allow more foreign workers into the country. The law will provide long-term work visas for immigrants in various blue-collar sectors, whereas the previous regulation allowed in only highly skilled workers. It will also enable foreign workers to upgrade to a higher-tier visa category, giving them a path to permanent residency, and allowing them to bring their families along.6  However, Japan’s closed culture raises the question of how successful Prime Minister Abe’s immigration reforms will be. The number of foreign residents has risen over the past few years, reaching a cumulative 2.73 million people, but this has been insufficient to reverse the decline in the population. In addition, without implementing effective measures to integrate new immigrants and support their efforts to become long-term residents, these reforms are likely to be minor in their impact (Chart 7, panel 3). Chart 8Aging Population = Slowing Productivity Aging Population = Slowing Productivity Aging Population = Slowing Productivity Japan’s population is not just shrinking but also aging. People aged 65 and older comprise 28% of the total population (Chart 7, panel 4). That figure is projected to reach 40% within the next 40 years. The dependency ratio – those younger than 15 years and older than 64, as a ratio of the working-age population – continues to rise rapidly (Chart 7, panel 5). Moreover, older people tend to be less productive. Because of this, Japan’s productivity may continue to decline from its current level, which is already low compared to other developed countries (Chart 8). The combination of a shrinking working-age population and poor productivity growth means that Japan’s trend real GDP growth over the next decade – absent an increase in capital expenditure or improvement in technology – is unlikely to be above zero.7   Some argue that Japan’s aging population could be the trigger to overcoming its disinflation problem. They argue that, as the share of the elderly-to-total-population increases, public expenditure on health care will balloon. The United Nations projects the median age in Japan to be 53 years, 10 and 5 years older than in the U.S. and China, respectively, by 2060 (Chart 9). This implies that the Japanese government, which currently pays about 80% of total health care expenditure, will face an increasing burden from medical spending, elderly care, and public pension payments. These expenditures are projected to increase from 19% to 25% of GDP (Chart 9, panel 2). The government, therefore, may have no alternative but to resort to monetizing its debt to pay these bills, which would ultimately prove to be inflationary. Chart 9Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Chart 10 In some countries, BCA has argued, an aging population is inflationary because retirees’ incomes fall almost to zero after retirement, but expenditure rises, particularly towards at the end of life as they spend more on health care.8 The resulting dissaving, and disparity between the demand and supply of goods, should have inflationary effects. But this rationale does not hold for Japanese households. Older people in Japan tend to maintain their level of savings (Chart 10). This phenomenon might change as a new generation, keener on leisure activities and less culturally attuned to maximizing savings, retires. But to date, at least, Japan’s aging process has been disinflationary. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Moreover, to reduce the burden on its budget, the government will continue its efforts to keep down health care costs, which have a 5% weight in the core core inflation measure. We find it unlikely, therefore, that the BoJ will achieve its 2% inflation target over the next few years. So, What Else Could The BoJ Do? Chart 11The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out Over the past six years, since Kuroda became governor in 2013, the Bank of Japan has rolled out aggressive monetary easing. It has cut rates to -0.1% and introduced a policy of “yield curve control,” which aims to keep the yield on 10-year JGBs at 0%, plus or minus 20 basis points. As a result, it now holds JPY479 trillion of JGBs, or 46% of the total outstanding amount (and equivalent to 89% of Japan’s GDP). It has also bought an average of JPY6 trillion of equity ETFs a year over the past three years (Chart 11, panels 1 & 2), to bring its total equity ETF holdings to JPY28 trillion, almost 5% of Japan's equity market cap. However, as noted above, these policies have had little impact on inflation, or on inflation expectations. BCA’s Central Bank Monitor indicates that Japan needs to ease monetary conditions further (Chart 11, panel 3). What alternative tools could the BoJ use to spur inflation? The BoJ could cut rates further, and indeed the futures market is discounting a 10 basis points cut over the next 12 months (Chart 11, panel 4). In its July Monetary Policy Committee meeting, the bank committed to keeping policy easy “at least through around spring 2020.” But it seems reluctant to cut rates, given that this would further damage the profitability of Japan’s banks, particularly the rather fragile regional banks. Indeed, one can argue that a small rate cut would be unlikely to have much effect, given the impotence of previous such moves. The BoJ might be inclined to emulate the ECB and extend its asset purchase program. It owns only JPY3 trillion of corporate bonds, and has bought almost no new ones since 2013 (Chart 11, panel 5), although the small size of the Japanese corporate bond market would give it limited scope to increase these purchases. It could also increase its purchases of REITs, of which it currently owns JPY26 trillion. It could even consider buying foreign assets (as does the Swiss National Bank), though this would annoy the U.S. authorities, who would consider it currency manipulation. Some economists argue in favor of a Japanese equivalent of the ECB’s Targeted Long-Term Refinancing Operations (TLTRO). In other words, the BoJ should provide funds to banks at rates significantly below zero, provided they use the proceeds to give out loans to households and corporations.9 This would not only increase credit in the economy, but also bolster banks’ declining profitability. Some academics consider Japan, which appears stuck in a liquidity trap, as the perfect setting to try out Modern Monetary Theory (MMT).10,11 However, the Ministry of Finance remains fixated on reducing Japan’s excessive pile of outstanding government debt, which is currently 238% of GDP. When MMT was debated in the Japanese Diet this June, Finance Minister Taro Aso dismissed it, saying “I’m not sure I should even call it a theory, it’s a line of argument,” and insisted that tax hikes are necessary to secure Japan’s welfare system. The Ministry’s current plan is to close the primary budget deficit by 2027.  Moreover, the Bank of Japan Law bans the central bank from underwriting government debt, due to the abuses of this in the 1930s, when it funded Japan’s militarist expansion12 – though there are no limits on how much the BoJ can buy in the secondary market.  Our conclusion is that negative rates and quantitative easing have reached the limit of their effectiveness. Even if the BoJ ramps up the measures it has taken up until now, this will have little impact on inflation. It will be only when the government finally understands that a combination of easy fiscal and monetary policy is single effective tool left that the situation can change. There is little sign of this happening soon. It will probably take a crisis before this mindset shifts. Are There Any Signs Of Improvement In Japan’s Banking Sector? Japan’s financial sector is also one of its longstanding problems. After Japan’s 1980s bubble burst, the BoJ aggressively cut rates from 6% to 0.5% over the span of eight years. Long-term rates also fell. Falling interest rates reduced Japanese banks’ net interest margins. The banks spent the 1990s cleaning up their balance sheets and recapitalizing themselves. In the end, the banks’ cumulative losses (including write-offs and increased provisioning) during the 1992-2004 period reached the equivalent of 20% of Japanese GDP.13 Japanese bank stocks have consistently underperformed the aggregate index since the late 1980s (with the exception of a short period in the mid-2000s) – and by 75% since 1995 (Chart 12, panel 1). It now seems like banks' relative performance is bound by the policy rate. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Bank loan growth throughout the period of 1995-2006 was weak or negative, as banks became more risk averse and borrowers focused on repairing their balance sheets (Chart 12, panel 2). It has picked up a little over the past decade, but remains low at around 2%-4%. This has been a drag on economic activity since both Japan’s corporate and household sectors rely much more heavily on banks for funding compared to the U.S. or the euro area (Chart 12, panels 3 & 4). As a result of stagnant loan growth at home, Japanese banks have in recent years expanded their activities overseas, particularly in south-east Asia. Foreign lending for Japan’s three largest banks comprises 29.7% of total loans, 33% of which is to Asia.14 This represents a risk for future stability since these assets could easily become non-performing in the event of an Emerging Markets crisis in the next recession. Chart 12Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Chart 13...Because Of Weak Loan Growth ##br##And Poor Profits ...Because Of Weak Loan Growth And Poor Profits ...Because Of Weak Loan Growth And Poor Profits By the mid-2000s, Japanese banks had finished cleaning up from the 1980s bubble and the non-performing loan ratio is now low. But measures of profitability such as return on assets and net interest margin remain poor by international standards (Chart 13). Japanese financial institutions’ capital adequacy ratios have also deteriorated moderately over the past five years, according to the BoJ’s Financial System Report, as risk-weighted assets have increased more quickly than profits. The core capital adequacy ratio of just above 10% is significantly lower than in other major developed economies.15 How Should Investors Be Positioned In The Short-Term? There are two factors that will determine how Japanese equities perform over the next 12 months: Chinese stimulus, and the impact of the consumption tax hike in October. Can Chinese Reflation Help Boost Japanese Economic Activity? Chart 14Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chart 15...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted While Japan is not a particularly open economy – exports represent only 15% of GDP – its manufacturing sector is very exposed to global trade, and the swings in this sector (which is a lofty 20% of GDP) have a disproportionately large marginal impact on the overall economy. China accounts for 20% of Japan’s exports, roughly 3% of Japan’s GDP (Chart 14). China’s economic slowdown since 2017 has clearly weighed heavily on Japanese exports and the manufacturing sector. Japanese machine tool orders have contracted for nine months, in June reaching the lowest growth since the GFC, -38% year-on-year. Vehicle production growth has also been weak, rising only 1.8% year-to-date compared to 2018, and overall industrial production growth has turned negative, falling by 4.1% YoY in June. It seems that global growth data has not yet bottomed. The German manufacturing PMI remains well below the boom/bust line at 43.2. Korean export growth is also contracting at a double-digit rate. Nevertheless, we expect the global manufacturing downturn – which typically lasts about 18 months from peak-to-trough – to bottom towards the end of this year.16 This will be supported by the Chinese authorities accelerating their monetary and fiscal stimulus, although the magnitude of this might not be as big as it was in 2012 and 2015.17 Japanese economic activity has historically been closely correlated with Chinese credit growth, with a lag of six-to-nine months (Chart 15). What Will Be The Impact Of The Consumption Tax Hike? Japanese consumer demand has been sluggish for some time, mainly as a result of low wage growth. The planned rise in the consumption tax from 8% to 10% in October is likely to dampen consumption further. With the economy currently so weak, there seems little justification for a tax rise. But, having postponed it twice, it seems highly unlikely that Prime Minister Abe will do so again, particularly after his victory in last month’s Upper House election, which was a de facto referendum on the tax hike. Chart 16Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly The OECD, based on Japanese government data, estimates the impact on households of the tax hike will be 5.7 trillion yen (about 1% of GDP).18 Consumers did not take previous tax rate hikes well. Spending was brought forward to the two to three months immediately before the hike. However, following the hike, not only did sales fall back, they also trended down for some time (Chart 16). The risk to the economy is that the same happens again.  The government, however, is planning several measures to mitigate the tax burden (Table 1). It will not apply the tax increase to food and beverages, which will stay at 8%. The government will implement a fiscal package including free early childhood education, support for low-income earners, and tax breaks on certain consumer durable goods, such as automobiles and housing. It will also introduce a rebate program, to encourage consumer spending at small retailers using non-cash payments (partly to reduce tax avoidance by these businesses).19 Based on the government’s estimates, these measures will be enough to fully offset the impact of the tax hike. However, the IMF’s Fiscal Monitor sees fiscal policy tightening due to the tax rate hike, although by less than in 2014. Its estimate is a drag of 0.6% of potential GDP in 2020 (Chart 17). Table 1Easing The Tax Hike Burden Japan: Frequently Asked Questions Japan: Frequently Asked Questions Chart 17Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary   Previous sales tax hikes caused a short-lived jump in inflation, which trended lower afterwards. Assuming a full pass-through rate of price increases to consumers, the BoJ expects the hike to raise core inflation by +0.2% and +0.1% in fiscal years 2019 and 2020 respectively.20 Consumers did not take previous tax rate hikes well. As such, over the next 12 months, Global Asset Allocation recommends an underweight on Japanese equities. While a bottoming of the global manufacturing cycle and the impact of Chinese stimulus are positive factors, there are better markets in which to play this, given the risks surrounding Japanese consumption caused by the consumption tax rise. Are Improvements In Corporate Governance Enough To Make Japanese Equities A Long-Term Buy? Chart 18Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Many investors believe that improved corporate governance could be the catalyst the stock market needs to outperform. It is true that there have been some improvements in recent years. Japanese companies have increased the share of independent directors on their boards, although this remains low by international standards (Chart 18, panel 1). Share buybacks have increased, and are on track to hit all-time high this year (Chart 18, panel 2). However, the improvements are still somewhat superficial. Cash holdings of Japanese companies are about 50% of GDP and 100% of market capitalization. The dividend payout ratio, at 30%, is significantly lower than in other developed markets, for example 40% in the U.S. and 50% in the euro area (Chart 18, panels 3 & 4). Why haven’t Japanese corporations returned their excess cash to shareholders? The answer is that many companies simply do not believe that they hold excess cash (Chart 19). The lack of a vibrant market for corporate control, and the general failure of activist foreign investment funds in Japan, means there is also less pressure on companies to use cash efficiently, and to raise leverage to improve their return on equity. The growing presence of the BoJ in the stock market is also a concern. The BoJ now holds over 70% of outstanding ETF equity assets, and is on track to become the single largest owner of Japanese stocks within a couple of years. With the BoJ not taking an active role as a shareholder, this risks undermining corporate governance reforms.21 It also suggests that, without the BoJ’s equity purchases over the past few years, Japanese equities might have performed even worse. Foreign investors have been the main buyers of Japanese equities over the past two decades, offsetting net selling by domestic households and most types of financial institutions. But foreign purchases have recently started to roll over, a trend that could be another catalyst for downward pressures on the stock market, if it were to continue (Chart 20). Chart 19 Chart 20Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't?   We conclude, therefore, that signs of improvement in corporate governance are still sporadic and not sufficient to justify a major rerating of the Japanese corporate sector.   Bottom Line GAA recommends an underweight on Japan over a 12-month time horizon, since the drag on consumption from the tax hike will override any positive impact from a rebound in global growth caused by Chinese stimulus. In the longer term, a stubborn refusal to use fiscal policy as well as monetary easing, the limited improvement in corporate governance, and Japan’s intractable structural problems such as demographics, mean it is hard to make a strong rerating case for Japanese equities.   Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Quarterly Portfolio Outlook, “Precautionary Dovishness – Or Looming Recession?” dated July 1, 2019, available on gaa.bcaresearch.com. 2      The BoJ calculates core inflation as headline inflation less fresh food, and core core inflation as headline inflation less fresh food and energy. 3      Please see “Outlook for Economic Activity and Prices (July 2019),” Bank Of Japan, July 2019. 4      Please see “Energy transition Japan: 'We have to disrupt ourselves,' says TEPCO,” Engerati, April 24, 2017.   5      Wage growth is total cash earnings, which includes regular/scheduled earnings plus overtime pay plus special earnings/bonuses. 6      Menju Toshihiro, “Japan’s Historic Immigration Reform: A Work in Progress,” nippon.com, February 6,2019. 7      Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019, available at gaa.bcaresearch.com. 8      Please see Global Asset Allocation Special Report, “Investor’s Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com. 9      Takuji Okubo, “Japan’s dormant central bank may have to rouse itself once more,” Financial Times, May 27, 2019. 10     The core idea of MMT is that, since governments can print as much of their own currency as they require, they do not need to raise money in order to spend money. Japan could increase its fiscal spending and, as long as the BoJ bought the increased bond issuance, this would not raise interest rates. 11     Please see Global Investment Strategy Special Report, “MMT And Me,” dated May 31 2019, available at gis.bcaresearch.com. 12     Please see Global Asset Allocation Special Report, “The Emperor’s Act Of Grace,” dated 8 June 2016, available at gaa.bcaresearch.com. 13     Mariko Fujii and Masahiro Kawai, “Lessons from Japan’s Banking Crisis 1991-2005,” ADB Institute Working Paper, No. 222, June 2010. 14     Mizuho, Mitsubishi UFJ and Sumitomo Mitsui. Data from March 2019 annual reports. 15     Please see “Financial System Report,” Bank of Japan, April 2019. 16       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com. 17       Please see GAA’s latest Monthly Portfolio Update, “Manufacturing Recession, Consumer Resilience, Dovish Central Banks,” dated 1 August 2019, available at gaa.bcaresearch.com. 18     Please see “OECD Economic Surveys: Japan,” OECDiLibrary, April 15, 2019. 19     Please see “Government plans 5% rebates for some cashless payments after 2019 tax hike,”The Japan Times, November 22, 2018. 20     Please see “Outlook For Economic Activity And Price (July 2019),” Bank Of Japan, July 30, 2019. 21     Andrew Whiffin, “BoJ’s dominance over ETFs raises concern on distorting influence,” Financial Times, March 31, 2019.

Analysis on India is available below. Highlights Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. As EM currencies depreciate, driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and EM risk assets will plummet. Meanwhile, there are tell-tale signs of an incipient EM breakdown. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. Feature In our May 23 report titled The RMB: Depreciation Time? , we argued that the odds of an RMB depreciation were rising and that the currency would likely depreciate by some 6-8% versus the dollar. We contended that this would be bad news not only for EM currencies but also for all EM risk assets. EM fundamentals have been poor – both exports and cyclical domestic sectors have been contracting for some time. We illustrated the weak domestic demand conditions experienced by the majority of developing economies in our recent report, Domestic Demand In Individual EM Countries. Nevertheless, many investors have been ignoring the growing evidence of deteriorating growth conditions. The recent breakdown in the CNY/USD cross has reminded investors of the 2015 episode, when global risk assets – particularly in EM – tumbled following the yuan’s depreciation. We expect the RMB to depreciate by another 5-6% or so. We expect the RMB to depreciate by another 5-6% or so (Chart I-1). This will likely trigger a full-scale breakdown in EM risk assets. With respect to investor positioning, sentiment on EM was buoyant up until last week. Chart I-2 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures was elevated as of Friday August 2. Chart I-1More Downside In RMB More Downside In RMB More Downside In RMB Chart I-2Investor Sentiment On EM Was Positive As Of Last Week Investors Are Very Bullish On EM Investor Sentiment On EM Was Positive As Of Last Week Investors Are Very Bullish On EM Investor Sentiment On EM Was Positive As Of Last Week With negative news proliferating on many fronts – the U.S.-China confrontation, slumping global trade, shrinking EM profits, tumbling commodities prices and RMB depreciation – the risk of a portfolio capital exodus from EM is rising, and a liquidation phase is highly probable. Implications Of RMB Depreciation It is impossible to know whether the recent RMB depreciation was market-driven or engineered by the PBoC. Our best guess is that the latest RMB depreciation was driven by both market pressures as well as the authorities’ increased tolerance of a weaker RMB.  The mainland economy requires a weaker currency to counteract accumulating deflationary pressures from deteriorating domestic and foreign demand, as well as to offset rising U.S. import tariffs. The Chinese leadership likely regards RMB depreciation as an economic and political response to U.S. import tariffs. That said, the Chinese authorities have significant latitude to control the exchange rate, not only via selling the central bank’s foreign currency reserves and tightening capital controls but also by utilizing foreign currency forward swaps. Therefore, the RMB depreciation will run further but will unlikely spiral out of control. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular via the following two channels: Escalating competitive devaluation: The RMB is causing a breakdown in other Asian currencies, especially those exposed to manufacturing exports (Chart I-3). Critically, falling export prices herald currency depreciation not only in China but also in other Asian economies such as Korea, Singapore and Taiwan (Chart I-4). Chart I-3Breakdown In Emerging Asian Currencies Breakdown In Emerging Asian Currencies Breakdown In Emerging Asian Currencies Chart I-4Lower Export Prices Warrant Currency Depreciation bca.ems_wr_2019_08_08_s1_c4 bca.ems_wr_2019_08_08_s1_c4 Less Chinese imports = a drag on global trade: An RMB devaluation reduces Chinese importers’ purchasing power in U.S. dollar terms. The same amount of credit and fiscal stimulus in yuan when converted into U.S. dollars can be used to procure less goods and commodities. In brief, the gap between mainland imports in yuan and in dollars will widen (Chart I-5). Chart I-5Chinese Imports In Dollars Will Continue Shrinking Chinese Imports In Dollars Will Continue Shrinking Chinese Imports In Dollars Will Continue Shrinking Chinese imports in dollar terms will continue contracting. Many EM and some DM currencies will be negatively affected, since China is a major source of demand for these economies. Bottom Line: Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. An EM Breakdown Is In The Making There are a number of financial markets and individual share prices that have been forewarning of potential breakdowns in EM/China plays and global pro-cyclical assets. In particular: Having failed to break above its 200-day moving average, the Risk-On vs. Safe-Haven currency ratio1 has dropped below its three-year moving average (Chart I-6, top panel). This indicator has had a very high correlation with EM stocks and global materials equities. Hence, its breakdown heralds a gap down in EM share prices as well as global materials stocks (Chart I-6, middle and bottom panels). Chart I-6Beware Of Breakdowns bca.ems_wr_2019_08_08_s1_c6 bca.ems_wr_2019_08_08_s1_c6 The rationale for using the 400-day (18-month), 800-day (three-year) and other long-term moving averages is similar to why investors utilize the 200-day (nine-month) moving average. When a market fails to punch below or above any of its long-term moving averages, odds are that it will make a new high or low, respectively. We discussed these technical indicators and have offered empirical examples of how these signals have historically worked in principal markets such as the S&P 500 and U.S. bond yields in our past reports.   Base metals (including copper) and oil prices as well as global steel stocks have broken below their three-year moving averages (Chart I-7). Commodities prices have been exhibiting a very bearish chart formation, and will likely plunge further. BCA’s Emerging Markets Strategy team remains bearish on commodities prices, even though BCA’s house view is bullish. The primary basis for this divergence in view has been and remains the Chinese growth outlook. Chart I-7Commodities Are In A Trouble Spot Commodities Are In A Trouble Spot Commodities Are In A Trouble Spot Chart I-8Canary In A Coal Mine For Commodities Canary In A Coal Mine For Commodities Complex Canary In A Coal Mine For Commodities Complex Share price of Glencore – a major player in the commodities space – has plunged below its three-year moving average, which has served as a support a couple of times in recent years2 (Chart I-8). Crucially, this stock has exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads the U.S. manufacturing cycles and has formed a similar configuration as Glencore’s (Chart I-9). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Finally, the relative performance of S&P 500 global cyclical stocks versus global defensives3 has resumed its downtrend after failing to break above its 200-day moving average (Chart I-10). This foreshadows a poor global growth outlook and serves as a downbeat signal for global cyclical plays. Chart I-9Canary In A Coal Mine For U.S. Industrials Canary In A Coal Mine For U.S. Industrials Canary In A Coal Mine For U.S. Industrials Chart I-10A Message From S&P 500 Industry Groups A Message From S&P 500 Industry Groups A Message From S&P 500 Industry Groups Does all of the above imply that the global growth slowdown is already priced into global financial markets? Not necessarily. These breakdowns have occurred on the fringes of markets. As the average investor heeds to these signals and as these breakdowns move from the periphery to the center, there will be more damage to global risk assets in general and EM in particular. Importantly, there are cyclical segments of global and EM financial markets that have not adjusted and remain vulnerable. For example, global semiconductor stocks and global industrial share prices remain elevated despite the enduring global manufacturing recession (Chart I-11). Chart I-11Mind The Gaps Mind The Gaps Mind The Gaps The wide gap between share prices and revenues of these cyclical sectors implies that investors have been pricing an imminent business cycle recovery. Odds are that the current global manufacturing downturn will last longer or that a bottoming-out phase will be more extended than in 2012 and 2015. We have elaborated on the rationale for a more extended downturn in our past reports, and our conclusions still stand: A lack of aggressive stimulus in China, a lower propensity to spend among Chinese households and companies, as well as the ongoing trade war will continue to dampen business sentiment worldwide. Consequently, the current gap between share prices of these cyclical sectors and their underlying revenues will likely be closed via lower stock prices. As to non-cyclical equity sectors, they are less vulnerable to a profit downturn but their valuations are very expensive, and investor positioning is heavy. Further, EM local currency bonds as well as EM sovereign and corporate credit markets have been buoyant because of falling U.S. interest rates. Yet EM currencies are at risk from both RMB devaluation and falling commodities prices. EM currency depreciation will in turn undermine returns on EM local currency bonds and spur an investor exodus from high-yielding domestic bonds. Chart I-12Which Way These Gaps Will Close? Which Way These Gaps Will Close? Which Way These Gaps Will Close? Excess returns on EM sovereign and corporate credit have historically correlated with EM currencies and commodities prices as well as with equity returns (Chart I-12). Commodities prices, EM currencies and share prices are all poised to weaken further. It will be very surprising if sovereign and corporate spreads do not widen from their current tight levels. Bottom Line: There are a number of tell-tale signs of an incipient EM breakdown. As EM currencies depreciate driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and all EM risk assets will plummet. Investment Recommendations We are reiterating our negative stance on EM currencies and risk assets both in absolute terms and relative to their DM counterparts. Our recommended country overweights and underweights for EM equity, sovereign credit and local currency bond portfolios are always available at the end of our reports (please refer to pages 18 and 19 ). As to exchange rates, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. In a nutshell, EM currency depreciation will -- for now -- overwhelm the positive impact of lower domestic interest rates on EM equities and in some cases will prevent developing nations’ central banks from reducing rates further. Finally, we recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely (Chart I-13). Gold has made a structural breakout versus the rest of commodities complex and investors should hold into this position. We recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely. Chart I-13A Structural Breakout In Gold Versus Oil And Copper A Structural Break In Gold Versus Oil And Copper A Structural Break In Gold Versus Oil And Copper Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indian Stocks: Poor Profit Outlook Amid Rich Valuation Indian stocks have failed to break out above their highs, in both local currency and U.S. dollar terms, and have rolled over decisively (Chart 1, top panel). Chart II-1Indian Stocks Failed To Break Major Resistance Levels Indian Stocks Failed To Break Major Resistance Levels Indian Stocks Failed To Break Major Resistance Levels Relative to the EM equity benchmark, Indian share prices have recently been underperforming despite collapsing oil prices and plunging U.S. interest rates. Furthermore, this bourse’s relative performance against the global equity index in common currency terms has bounced lower from a major structural technical resistance (Chart II-1, bottom panel). India’s recent underwhelming equity dynamics have transpired despite ongoing monetary policy easing by the country's central bank. In a nutshell, the roots of this poor equity performance trace back to lackluster profitability, rich equity valuations and overcrowded positioning. We recommend investors continue avoiding Indian equities for now as more downside is likely. Domestic Growth/Corporate Earnings Slump Indian domestic demand growth has been nosediving with no clear end in sight: Sales of passenger cars, two-wheelers, three-wheelers, tractors as well as medium & heavy commercial trucks are all contracting at double-digit rates (Chart II-2). Similarly, real gross fixed capital formation growth has decelerated, the number of capex projects underway are falling, capital goods imports and production are contracting and cement production growth has plummeted (Chart II-3). Chart II-2Domestic Demand Is Very Weak Domestic Demand Is Very Weak Domestic Demand Is Very Weak Chart II-3Capex And Infrastructure Are Heading South Capex And Infrastructure Are Heading South Capex And Infrastructure Are Heading South Some cracks are also appearing in India’s real estate sector. Chart II-4 shows nationwide housing price growth is decelerating in nominal terms and deflating in real (inflation-adjusted) terms. Chart II-4House Prices Are Contracting In Real Terms House Prices Are Contracting In Real Terms House Prices Are Contracting In Real Terms Typically, share prices become extremely sensitive to business cycles slowdowns when valuations are elevated. This is currently the case for the Indian bourse. In fact, India’s latest corporate earnings season was lackluster and many companies across various sectors have warned about slowing growth. More visibility on an ameliorating profit outlook as well as lower valuation multiples are needed for share prices to reach a sustainable bottom. India Is Joining The “Kick The Can Down Road” Club Banks have been the star performers within the Indian bourse with non-financials generating underwhelming returns. This warrants particular attention to bank stocks’ fundamentals and valuations. Recent media reports have been highlighting that India’s NPL cycle has finally turned for the better – marking an end to the country’s bad asset cycle that started in 2013. Chart II-5Poor Debt Servicing Ability Among Indian Corporate Borrowers Poor Debt Servicing Ability Among Indian Corporate Borrowers Poor Debt Servicing Ability Among Indian Corporate Borrowers However, scratching below the surface, the recent reduction in India’s NPLs ratio has not occurred due to organic improvement in India’s corporate borrowers’ ability to service debt. For instance, the EBITDA-to-interest expense ratio for the country’s non-financial publically-listed companies has not improved at all (Chart II-5). Rather, what seems to be driving the NPLs ratio lower is a regulatory forbearance: The new Governor of the RBI – Shaktikanta Das – issued a new circular on NPL recognition in June. It essentially provides commercial banks with much more flexibility in the way they can deal with their bad assets and permits them to delay their NPL recognition. The central bank also allowed India’s manufacturing and infrastructure corporates in default to borrow via the External Commercial Borrowing route in order to pay down their domestic loans under a one-off settlement. Furthermore, the RBI permitted commercial banks to restructure loans of micro-, small-, and medium-sized businesses before they turn bad - allowing banks to delay the proper recognition of such types of loans as well. Finally, the RBI reduced the risk weight of consumer credit from 125% to 100% in its monetary policy meeting yesterday. The objective of this measure is to accelerate consumer credit growth even though the latter has been booming in the past ten years. All in all, these regulatory measures reverse banks and corporate sector restructuring efforts and thereby are negative from a structural perspective. In the past, we were positive on the Indian banking system structurally because the central bank was promoting critical reforms.   Under the new leadership of the RBI, India is now joining the “kick the can down the road” club. This warrants somewhat lower equity multiples for banks than before. Financials Stocks Are Still Expensive Despite the selloff, Indian bank stocks are not yet cheap. For Indian public banks we focused our analysis on the State Bank of India (SBI) as it is the largest and only public bank that has performed reasonably well. This bank presently trades at a price-to-book value (PBV) ratio of 1.15.  Our analysis shows that at a more realistic 12% NPL ratio4 and assuming a 30% recovery ratio, 25% of its equity would be impaired. This would move its adjusted PBV ratio to 1.5. Assuming a fair-value PBV ratio of 1.3, the SBI appears to be overvalued by 15-17%. As to private banks,5 they are also expensive. For instance, if their NPLs rise to 6% from around 3% currently, they would seem overvalued by at least 12% (Table II-1). The analysis assumes a generous recovery ratio of 50% and a very high fair-value PBV ratio of 3.3.  Chart II- Finally, a comment on non-bank financial companies (NBFCs) is warranted. Their liquidity situation is extremely grim. Chart II-6 shows that our proxy for liquidity, measured as short-term investments (including cash) minus short-term borrowing for the 11 large NBFCs we assessed,6 is in a deep negative territory. In other words, these companies have a substantial maturity mismatch. Chart II-6Major Asset-Liability Mismatches In Non-Bank Finance Sector Major Asset-Liability Mismatches In Non-Bank Finance Sector Major Asset-Liability Mismatches In Non-Bank Finance Sector Remarkably, these non-bank organizations grew their assets at a 20% annual compounded growth rate since 2009. Odds are they have misallocated capital to a large extent and their NPL ratio is probably in the double-digits. According to the RBI, non-bank financials’ gross NPLs ratio stood at 6.6% as of March 2019. By comparison the NPLs ratio of Indian banks peaked at 11.2%. Meanwhile, their valuations are not cheap at all. For instance, the NBFCs included in the MSCI India equity index carry a PBV ratio of 3.5 for consumer finance focused companies and a PBV ratio of 3 for thrift & mortgage finance focused companies. Bottom Line: Share prices of banks and non-bank financials are far from being cheap and remain at risk of further decline. Investment Recommendations In absolute U.S. dollar terms, Indian stocks have meaningful downside. This is confirmed by some precarious technical signals: the equal-weighted stocks index has dropped by 28% from its top in January 2018 and small-cap stocks are breaking down (Chart II-7). Finally, while the RBI cut rates yesterday, share prices still closed lower. Chart II-7Ominous Signals From The Indian Broader Equity Market Ominous Signals From The Indian Broader Equity Market Ominous Signals From The Indian Broader Equity Market In terms of our relative strategy, we continue to recommend that dedicated EM equity investors keep underweighting Indian stocks for now, but our conviction level is lower than it was in May. The basis is that ongoing fiscal and monetary easing, coupled with very low U.S. bonds yields and oil prices, might help Indian equities to outpace their EM peers at some point. For now, we will wait for a better entry point to upgrade. Our strongest conviction is that Indian stocks will underperform the global equity index in common currency terms (please see Chart II-1 on page 11). As for the currency, lingering problems in the NBFC sector will force the RBI to keep liquidity in the banking system abundant. Excessive liquidity expansion amid the ongoing selloff in EM currencies will hurt the rupee. Fixed-income investors should play a yield curve steepening trade as lower short rates and rupee deprecation could generate a yield curve steepening. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      The drop occurred well before the latest negative profit report. 3      These indexes are based on U.S. S&P 500 industry groups and published by Goldman Sachs. The Bloomberg tickers for S&P 500's global cyclicals and global defensives indexes are GSSBGCYC and GSSBGDEF, respectively. 4      Instead of the 7.5% ratio it reported last week. 5      We analyzed the six largest private banks: HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, IDFC First Bank and Kotak Mahindra Bank 6      Six of which are listed in the MSCI India equity index and account for 12% of MSCI total market cap. Equity Recommendations Fixed-Income, Credit And Currency Recommendations  

Just as it appeared the slowdown in global industrial activity had run its course, commodity markets face another test of demand resiliency brought on by exogenous political shocks (Chart Of The Week). As luck would have it, these shocks – arriving in the form of an unexpected escalation of Sino-U.S. trade tensions – came on the heels of reports of further weakness in global manufacturing activity, a less-dovish-than-expected Fed, and a breach of the 7.0 level of the RMB/USD cross. The fallout – a global risk-off event – raises the spectre of a deeper trade war damaging EM GDP growth, which would weaken commodity demand. We continue to expect global fiscal and monetary stimulus to revive commodity demand, albeit further out the curve – i.e., later this year, as opposed to earlier in 2H19. Given the trade-war escalation, we are recommending a tactical long position in spot silver to hedge portfolio risk. The metal has been tracking gold’s ups and downs post-GFC – more so than industrial demand for silver – indicating it may have some catching up to do. This will make us strategically long gold, and tactically long silver at tonight’s close. Chart Of The WeekRenewed Trade Tensions Threaten Industrial Commodities' Recovery Renewed Trade Tensions Threaten Industrial Commodities' Recovery Renewed Trade Tensions Threaten Industrial Commodities' Recovery   Highlights Energy: Overweight. U.S. President Trump informed Congress earlier this week he was imposing a total economic embargo on Venezuela, which freezes assets of the Maduro government and all business dealings with its representatives except for humanitarian aid. Venezuela’s oil production averaged ~ 750k b/d in 2Q19, and was supported by the assistance of Russian technicians, U.S.-based Chevron Corp., and four service companies that were granted 90-day waivers by the U.S. to continue to do business in the country.1 Our long Sept19 Brent vs. short Sept20 Brent position expired with a gain of 101.7%. We remain long 4Q19 Brent vs. short 4Q20 Brent. Base Metals: Neutral. Industrial metals, iron ore and steel came under renewed selling pressure this week, in the wake of heightened trade tensions between the U.S. and China. Precious Metals: Neutral. Safe-haven demand rallied gold 3% over the week ended Tuesday, following the escalation in Sino-U.S. trade tensions. We continue to favor gold as a strategic portfolio hedge, particularly if central banks are compelled to accelerate monetary accommodation as global trade tensions rise, and are adding a tactical long silver position to our recommendations. Ags/Softs: Underweight. China’s Commerce Ministry reported U.S. ag products no longer are being purchased by Chinese companies earlier this week.2 U.S. President Trump’s decision to impose tariffs on Chinese imports to the U.S. were occasioned by his claim China was not living up to an agreement to increase agricultural purchases. This broke the truce in the Sino-U.S. trade war that accompanied the resumption in negotiations last month. Feature A recovery in industrial-commodity demand – particularly for oil and base metals – could be stretched out longer than we expected just a week ago. It’s still too early to tell whether the escalation in Sino-U.S. trade tensions will throw a spanner into the revival of commodity demand we’ve been expecting, but it does give us pause. Prior to the political shocks and other disappointments hitting markets this past week, our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. EM GDP growth drives commodity demand growth globally, which is why it is so important in our analysis. Our Chart of the Week illustrates this point, showing three relationships we've developed that allow us to track the evolution of EM GDP growth in something close to real time: BCA’s Global Industrial Activity (GIA) index, which is highly sensitive to economic activity in EM generally and China in particular;3  BCA’s Global Commodity Factor (GCF), which condenses the information contained in 28 commodity price series to a common factor using principal components analysis; and BCA’s EM Import Volume model, which generates an expectation of EM import volumes using mainly FX values for countries highly exposed to global trade. To be precise, we find the output of these three models shown in the Chart of the Week and EM GDP growth are deeply entwined.4 As can be seen in the chart, these models appeared to have bottomed and were preparing to hook up. This is supported by current global activity indicators (CAIs), particularly for China and EM, which still is showing positive y/y growth, even if its rate is slowing. (Chart 2), and the recent upturn in EM Financial Conditions we track here at BCA Research (Chart 3).  Chart 2Global CAIs Support EM Growth Expectation Global CAIs Support EM Growth Expectation Global CAIs Support EM Growth Expectation Chart 3EM Financial Conditions Move To Easier Setting EM Financial Conditions Move To Easier Setting EM Financial Conditions Move To Easier Setting However, the escalation of Sino-U.S. trade tensions, coming off a somewhat disappointing Fed rate cut of 25bps and weak manufacturing data, was enough to erase 6% and 3% from the GSCI and Bloomberg commodity indices over the week ended Tuesday (Chart 4), and to lift volatility in industrial commodities’ prices sharply (Chart 5).5    Chart 4Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Chart 5Crude Oil, Copper Vol Jump On Policy Shock Crude Oil, Copper Vol Jump On Policy Shock Crude Oil, Copper Vol Jump On Policy Shock   A Fraught Situation The Sino-U.S. trade standoff is fraught with risk for both sides. A full-blown trade war could devolve into domestic recessions (there is a non-trivial risk to the global economy, as well). In addition, a kinetic military confrontation between China and its allies and the U.S. and its allies cannot be ruled out, as tensions rise. The case for resolving the trade dispute is strong. Our colleague Peter Berezin notes that while an escalation in the Sino-U.S. trade war “would tip the scales towards recession, the risk of such an outcome remains low.”6 An all-out trade war could push the U.S. economy into a recession next year, just as President Trump faced re-election, which strongly suggests a goodwill gesture or two from the U.S. – e.g., the Commerce Department renewing the licenses allowing U.S. firms to deal with Huawei – could go a long way to getting trade talks back on track.  Our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. That said, we cannot gainsay the conclusions of our colleague Matt Gertken, who runs our Geopolitical Strategy: “The U.S.-China trade negotiations are falling apart at the moment. … (B)ut with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling,” as U.S. and Chinese positions harden, particularly around North Korea, Hong Kong and Taiwan.7 Clearly, the outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated. Moving To A Safe Haven: Silver While we continue to expect global fiscal and monetary stimulus will revive commodity demand, the shocks and disappointments visited upon markets could incline firms, households and investors globally to scale back on risky investments and purchases until the dust settles.8  Over the near term – i.e., 3 months or so – seeking refuge in a safe haven is sensible. In particular, we believe silver offers near-term cover, and expect it will continue to follow the evolution of gold prices.9  We expect central banks generally – the Fed in particular – will err on the side of maintaining monetary accommodation while uncertainty over trade and global growth prospects remains elevated. Fed Chairman Jay Powell's description of the central bank's July rate cut of 25 bps as a mid-cycle adjustment – and not the beginning of a lengthy cutting cycle – was perceived as a hawkish surprise, but markets appear to be pricing in additional cuts this year, which will support precious metals until further guidance from the Fed arrives. An escalation of the trade war likely would increase the probability the Fed cuts rates further at its next meeting, which would push down recession fears. The outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated.   On the supply side, silver typically is mined as a secondary metal, and usually is found with gold, copper and lead deposits, according to the Silver Institute.10 On the demand side, investment and electronics account for much of the usage. Prior to the Global Financial Crisis (GFC), silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization, which led to higher consumption. This resulted in a large supply-deficit in most industrial commodities, including silver (Chart 6). Following the GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. (Chart 7).11  Chart 6Silver Is Less Industrial, More Precious Now Silver Is Less Industrial, More Precious Now Silver Is Less Industrial, More Precious Now Chart 7Post-GFC, Silver and Gold Are More Closely Aligned Post-GFC, Silver and Gold Are More Closely Aligned Post-GFC, Silver and Gold Are More Closely Aligned We expect this to continue, given our view central banks are likely to either increase or accelerate monetary accommodation to offset Sino-U.S. trade tensions, should they worsen. The U.S. dollar outlook remains important for precious metals. The dollar is a counter-cyclical currency. Thus, the escalation in trade tensions risks delaying the rebound we expect in emerging markets. This could support the USD for longer than we expected. Bottom Line: We expect commodity demand to revive on the back of global fiscal and monetary stimulus. However, exogenous political shocks along the way toward that revival likely will force households, firms and investors to re-think spending and investment decisions. This could potentially lead to reduced aggregate demand, in the event uncertainty around manufacturing, which still accounts for significant employment and output in EM economies, and global trade becomes too high. Until this is sorted, taking refuge in a safe haven is prudent. To hedge against this, we are recommending spot silver as a tactical portfolio hedge. We already are long gold as a strategic portfolio hedge, and this position is up 20% this year.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   1      Please see U.S. sanctions waiver for Chevron signals Venezuela solution near: opposition ambassador, published by S&P Global Platts July 30, 2019. 2      Please see U.S. farmers suffer 'body blow' as China slams door on farm purchases published by reuters.com August 5, 2019. 3      Please see Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published by BCA Research’s Commodity & Energy Strategy May 9, 2019, for a discussion of the GIA index. The index is a weighted average of selected trade, currency, manufacturing PMIs, and Chinese industrial sector variables. The article is available at ces.bcaresearch.com. 4      This is to say there is strong two-way Granger causality between EM GDP and the output of the models shown above in the Chart of the Week. Knowing the output of one of the models allows one to forecast EM GDP growth, and vice versa. We will be doing further research into using these models to estimate the change in EM GDP at a higher frequency than the stand-alone EM GDP data are reported – e.g., the World Bank’s most recent actual EM GDP data in constant 2010 USD is reported up to 1Q18, while the models shown in the chart can be updated daily (GCF and the EM Import Volume models); and monthly, as the components of the GIA index become available. 5      For a discussion of global fixed-income markets’ response to the escalation of the Sino-U.S. trade war and the outlook for more aggressive monetary policy accommodation globally, please see Trade War Worries: Once More, With Feeling, published by BCA Research’s Global Fixed Income Strategy August 6, 2019. It is available at gfis.bcaresearch.com. 6      Please see A One-Two Punch, published by BCA Research’s Global Investment Strategy August 2, 2019. It is available at gis.bcaresearch.com. 7      Please see Tariffs ... And The Last Prime Minister Of The United Kingdom?, published by BCA Research’s Geopolitical Strategy, August 2, 2019. It is available at gps.bcaresearch.com.  Almost on cue, China warned the U.S. it would view its deployment of intermediate-range missiles in Asia following Russia’s revival of its intermediate-range missile development as “offensive in nature.” Please see China warns US against deploying missiles on its ‘doorstep’, published by the Financial Times August 6, 2019.  8      Our global macro expectation can be found in Oil Markets Await Lift From Global Stimulus, published by BCA Research’s Commodity & Energy Strategy August 1, 2019. It is available at ces.bcaresearch.com. 9      Please see "The Gold Trifecta," published June 27, 2019, by BCA Research's Commodity & Energy Strategy, for our most recent analysis of the gold market and of our long-held bullish gold view. It is available at ces.bcaresearch.com. 10     The Institute’s supply-demand annual supply-demand balances showed a 29.2mm-ounce deficit in 2018. 11     When we model silver returns as a function of gold and base metals’ returns, silver’s elasticity to gold prices more than doubles – from 0.68 over the 1999 - 2010 period, to 1.67 post-GFC (2010 to now). The elasticity to changes in base-metals prices was roughly cut in half over this period, to 0.28 post-GFC.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights U.S.-China: The escalation of the trade war has renewed investor fears that uncertainty could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Fed: The Fed had an opportunity last week to regain control of monetary policy from the markets, but opted for only a cautious rate cut that came off as too hawkish. The FOMC will be forced to play defense in the next 3-6 months, likely by cutting rates more than originally envisioned given the market turbulence stemming from the trade war escalation. Fixed Income Asset Allocation: Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming. Feature A Painful Repricing Chart of the WeekNot A Pretty Picture Not A Pretty Picture Not A Pretty Picture A long-overdue correction in risk assets, or the start of something more sinister? That is the question investors must now consider. Another Twitter blast from @realDonaldTrump has triggered chaos in global financial markets, with the imposition of fresh U.S. tariffs on Chinese imports. This shattered the market calm since the June G20 meeting, when an announced truce on the U.S.-China trade dispute led to optimism that a real deal could be reached. China retaliated to the new tariffs by allowing the USD/CNY exchange rate to depreciate beyond the perceived line in the sand at 7.0. The trade news came at a bad time for financial markets, a few days after the release of soft global manufacturing PMI data for July that highlighted how global growth remains highly vulnerable to trade war developments (Chart of the Week). The Fed did not help matters by delivering an interest rate cut last week but somehow coming across as hawkish (or, at least, not dovish enough). The market response to the renewed trade tensions and yuan weakness has been classic “macro risk-off” – sharply lower government bond yields, alongside big declines in global equity markets and commodity prices (Chart 2) and increases in the value of typical safe-havens like gold and the Japanese yen (Chart 3). Chart 2Growth-Sensitive Assets Not Doing Well Growth-Sensitive Assets Not Doing Well Growth-Sensitive Assets Not Doing Well Chart 3Safe Havens In Demand Safe Havens In Demand Safe Havens In Demand The nature of the fall in global bond yields has been consistent with what has been seen so far in 2019 – fairly coordinated moves in terms of size, with much smaller changes seen in cross-country yield spreads. This suggests that the unobservable “global” bond yield is falling in response to deteriorating global growth expectations, rather than country-specific factors driving local bond yields. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. We admit that our current duration recommendations have not been aligned to benefit from these moves. Our forecasting philosophy for government bond yields is based on what our colleagues at our sister service, BCA U.S. Bond Strategy, have dubbed “The Golden Rule of Bond Investing”.1 In that framework, the primary driver of government bond market returns (excess returns over cash, to be precise) is the outcome of central bank policy moves versus what is discounted in interest rate markets. In the U.S., we have been steadfast in our expectation that the Fed would disappoint market pricing that was calling for as much as 90bps of rate cuts over the next 12 months. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. Chart 4Rate Cuts Required - And Discounted - Everywhere Rate Cuts Required - And Discounted - Everywhere Rate Cuts Required - And Discounted - Everywhere Now, with the President giving markets the unpleasant news that a trade deal with China is not imminent, and new tariffs about to be imposed, the pressure is on the Fed to provide an offset through easier monetary policy. Some are even interpreting the timing of Trump’s latest Tariff Tweet in a Machiavellian fashion, as if he wanted to create more uncertainty to get to Fed to cut rates (and, by association, help deliver Trump’s goal of weakening the U.S. dollar). On the surface, Trump ratcheting up the trade tensions sounds like a risky economic game to play leading up to the 2020 Presidential election. Our colleagues at BCA Geopolitical Strategy, however, note that many of the leading Democratic presidential nominee contenders have themselves been pushing for a more hawkish stance on China. Trump may now feel politically emboldened to become even harder on China himself, to avoid being outflanked by the Democrats – even if it means the U.S. stock market suffers a nasty selloff as a result. Although, again, if the Fed cuts rates as a result, Trump will likely view that as a victory given his constant haranguing of Fed Chair Jay Powell over the past year. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened – even though it is still debatable whether the U.S. economy has softened enough to justify a full-blown easing cycle. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened Our Central Bank Monitors are now signaling a need for some easing of monetary policy in all the major developed economies, including the U.S. (Chart 4). Even though our 12-month Discounters also show that a lot of easing is already priced into Overnight Index Swap (OIS) curves in those same countries, the amount of cuts discounted is consistent with the dovish message from our Central Bank Monitors. Given the renewed trade tensions, alongside no signs of much improvement in overall global growth momentum, we are less certain at the moment that the amount of cuts discounted by markets will not be delivered. Thus, under our Golden Rule framework, a below-benchmark overall global duration stance is not warranted at this time. Therefore, this week, we are increasing our overall duration stance to neutral from below-benchmark, on a tactical basis. In our model bond portfolio on Page 10, we are implementing this view by “neutralizing” the duration exposures within each country. This is done by keeping the same total country weightings versus the benchmark index, but allocating across all maturities in line with the index weightings within each country. This adds about one-half of year of duration to the model portfolio to bring it up the same level as the benchmark index, but without altering the overall allocations to countries or spread product sectors. What To Do Beyond The Short-Term? Chart 5A Lot Of Bad News Discounted In Bond Yields A Lot Of Bad News Discounted In Bond Yields A Lot Of Bad News Discounted In Bond Yields Despite the near-term concerns and volatility stemming from the increased trade tensions, we do not advocate moving to a more defensive portfolio allocation (above-benchmark duration, underweight corporate bonds) to position for a deeper global growth slowdown, for the following reasons: A lot of bad news is already discounted in global bond yields. The rally in government bond markets this year has pushed bond yields down to stretched levels using typical valuation metrics (Chart 5) like the 5-year OIS rate, 5-years forward; the term premium on 10-year yields, and market-implied inflation expectations from CPI swaps or inflation-linked bonds. Additional sustainable declines will be harder to achieve from current levels. The U.S. economy is still holding up relatively well, especially compared to other major economies. Although the U.S. manufacturing sector data has slowed, U.S. Treasury yields already are in line with the diminished readings of the ISM Manufacturing index, which is still above the 50 level signifying expanding activity (Chart 6). The non-manufacturing (services) side of the economy has not seen the same degree of slowing, while consumer confidence and retail sales have both picked up of late. Also, the mean-reverting U.S. data surprise index – which is correlated to the momentum of bond yields – is very stretched to the downside, suggesting less downside potential for Treasury yields from weak U.S. data (Chart 7). Chart 6UST Yields Consistent With Slower Manufacturing UST Yields Consistent With Slower Manufacturing UST Yields Consistent With Slower Manufacturing In addition, the easing of U.S. financial conditions from the 2019 rally in U.S. equity and credit markets before the past few days does suggest a rebound in U.S. growth is likely beyond the next few months. It will take much bigger market declines than seen so far, something beyond a mere “garden-variety” correction in U.S. equities, to tighten financial conditions enough to offset the prior loosening. Chart 7Treasuries Are Vulnerable To Better Data Treasuries Are Vulnerable To Better Data Treasuries Are Vulnerable To Better Data Early leading indicators are flashing a future bottoming of global growth. Several of the more reliable leading economic signals, like our global LEI diffusion index and the China credit impulse, are both flashing the potential for a rebound in global growth to begin around the end of the year (Chart 8). If Chinese policymakers choose to offset the negative domestic economic impact of the new Trump tariffs with even more stimulus measures, as seems likely, then the odds of an eventual growth rebound would improve – especially if there is also a healthy dose of monetary easing from the Fed, ECB (both rate cuts and renewed asset purchases) and other major central banks. Early leading indicators are flashing a future bottoming of global growth. Summing it all up, we see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. It would take signs that the improvement in leading economic indicators is reversing to justify downgrading global corporate bond exposure. We think it more likely that we’ll be reducing our recommended duration exposure back to below-benchmark sometime in the next few months. We will be watching news on global trade, China stimulus and U.S. non-manufacturing growth before making the next change to our duration call. We see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. With regards to country allocation within developed market government bonds, we are choosing to stick with our current recommendations: overweight core Europe, the U.K., Japan, Australia and Spain; underweight the U.S. and Italy; and neutral Canada (Chart 9). Those allocations have served us reasonably throughout 2019, with the bulk of the overweights outperforming the Bloomberg Barclays Global Treasury index in hedged USD terms, and the U.S. actually only just matching the global hedged benchmark (thanks to the yield pickup for non-U.S. debt from hedging currency exposure back to higher-yielding U.S. dollars). Chart 8A Light At The End Of The Tunnel? A Light At The End Of The Tunnel? A Light At The End Of The Tunnel? Chart 9We're Sticking With Our Country Allocations We're Sticking With Our Country Allocations We're Sticking With Our Country Allocations Only in the case of Italy, were we have maintained an underweight stance given our concerns about weak Italian growth and the implications for debt sustainability, have we seen a significant underperformance of our recommendation. At current yield/spread levels, however, we remain reluctant to simply chase higher-yielding Italian bond yields in the absence of any sign of improving Italian growth that would justify lower Italian risk premia. Bottom Line: The escalation of the trade war has renewed investor fears that trade could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Trade War Worries: Once More, With Feeling Trade War Worries: Once More, With Feeling Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns