Policy

Highlights So What? The Trump administration is focusing on re-election in 2020, which could push the recession call into 2021. Why? The midterms were investment-relevant, just not in the way most of our clients thought. We are downgrading our alarmism on Iran; Trump is aware of his constraints. But investor optimism regarding the trade war may be overdone. China has contained its capital outflows, which suggests Beijing will be comfortable with more CNY/USD downside. A new GPS mega-theme: Bifurcated Capitalism! Watch carefully for any upcoming trade action on semiconductors. Feature There is no better feeling than hearing from our clients that we got a call wrong because we misjudged the constraints of the Trump administration by focusing too much on its preferences. Why? Because it means that clients are keeping us honest by employing our most important method: constraints over preferences. This is one of the takeaways from a quarter filled with meetings with our clients in the Midwest, Toronto, Amsterdam, Rotterdam, The Hague, Frankfurt, Berlin, Auckland, Melbourne, Sydney, Dubai, Abu Dhabi, and sunny Marbella, Spain! In this report, we discuss several pieces of insight from our clients. Midterms Are Investment Relevant Generally speaking, few of our clients agreed with our assessment that the midterm elections were not investment-relevant. The further away from the U.S. we traveled, the greater the sense among investors that equity markets influence U.S. politics: both the upcoming takeover of the House of Representatives by the Democratic Party and the odds of trade war intensification. We strongly disagree with this assessment. Both periods of equity market turbulence this year were preceded by a rising U.S. 10-year yield, not any particularly damning trade war chatter (Chart 1). In fact, the intensification of the trade war this summer occurred amidst a fairly buoyant S&P 500! Meanwhile, the odds of a Democratic takeover of the House were priced in well before the October equity decline began. Chart 1Yields, Not Trade, Matter For Stocks Yields, Not Trade, Matter For Stocks Yields, Not Trade, Matter For Stocks Generally speaking, even midterms that produce gridlock have led to a relief rally (Chart 2). This time could be the same, especially because the likely next Speaker of the House, Nancy Pelosi, has signalled that the main policy goal for 2019 would be infrastructure spending. In her "victory" speech following the election, Pelosi mentioned infrastructure numerous times (impeachment, zero times). Chart 2Stocks Are Indifferent To Midterm Results Stocks Are Indifferent To Midterm Results Stocks Are Indifferent To Midterm Results Democratic Representative Peter DeFazio, likely head of the House of Representatives committee overseeing transportation, has already signalled that he will ask for "real money, real investment."1 DeFazio has previously proposed a $500bn infrastructure plan, backed by issuance of 30-year Treasuries and raising fuel taxes. He has rejected the February 2017 Trump proposal, which largely relied on raising private money for the job. Would President Trump go with such a plan? Maybe. In early 2018, he stunned lawmakers by saying that he supported hiking the federal gasoline tax by 25 cents a gallon (the federal 18.4 cent-a-gallon gasoline tax has not been hiked since 1993). He has since confirmed that "everything is on the table" to achieve an infrastructure deal. Several clients from around the world pointed out that both Democrats and President Trump have an incentive to make a deal. President Trump wants to avoid the deeply negative fiscal thrust awaiting him in 2020 (Chart 3). Given the House takeover by the Democrats, it is tough to imagine that new tax cuts are the means for Trump to avoid the "stimulus cliff." As such, another round of stimulative fiscal spending may be the only way for him to avoid a late-2020 recession (although the latter is currently the BCA House View). Chart 3Can Trump And Pelosi Reverse... Can Trump And Pelosi Reverse... Can Trump And Pelosi Reverse... Democrats, on the other hand, have an incentive to ditch "Resistance" and embrace policy-making. Yes, hastening the recession in 2020 would be the Machiavellian play, but President Trump would be able to blame Democrats for the downturn - since they will necessarily have had to participate in planning an infrastructure bill only to sink it. They also learned the lesson from the January 2018 government shutdown, which backfired at the polls and forced Senate Democrats to come to an agreement quickly on a two-year stimulative budget deal. What about the GOP fiscal conservatives? They don't necessarily need to come on board. The House is held by Democrats. And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given that infrastructure is popular, that the president will be pushing it, and that the GOP-controlled Senate agreed with the budget bill in January, we think that even more Republican Senators can go along with an infrastructure plan. Another big takeaway from the midterms is that the GOP suffered deep losses in the Midwest. President Trump's party lost ten out of twelve races in the region (Table 1). The two most representative contests were the loss of Republican Wisconsin Governor and one-time rising presidential star Scott Walker, and the victory of the left-wing and über-protectionist Democratic Senator Sherrod Brown of Ohio. Table 1Massive Republican Losses Across The Midwest Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing Senator Brown won his contest comfortably by 6.4% in a state that Trump carried by 8.13%. The appeal of Brown to the very blue-collar voters that Trump himself won is obvious. On trade, there is no daylight between the left-wing Brown and President Trump. Meanwhile, Walker, an establishment Republican who built his reputation on busting public-sector unions, could not replicate Trump's success in Wisconsin. Several of our clients suggested that the GOP performance in the Midwest was poor because of the aggressive trade rhetoric. But that makes little sense. Republicans did not run Trump-style populists in the Midwest, to their obvious detriment. Democrats have always claimed to be for "fair trade" rather than "free trade." And we know, empirically, that Trump saw a key swing of turnout in 2016 in these states, largely thanks to his protectionist rhetoric (Chart 4). Chart 4Trump Owes The Midwest The Presidency Trump Owes The Midwest The Presidency Trump Owes The Midwest The Presidency President Trump cannot take Michigan, Pennsylvania, and Wisconsin lightly. His performance in 2016 was extraordinary, but also tight. The Democrats will win these states if Trump does not grow voter turnout and support, according to demographic projections - and they lost them by less than a percentage point of white voters (Map 1). As such, we think that Democrats will talk tough on trade and try to reclaim their union and blue-collar voters, while President Trump has to double down on an aggressive trade posture towards China. Map 1Can 'White Hype' Work In 2020? Trump's Margins Are Small Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing The midterms are investment relevant after all, but not in the way some might think. The Democratic takeover of the House, and the resultant gridlock, will potentially avert the "stimulus cliff" in 2020. This ought to support short-term inflation expectations and thus allow the Fed to stay-the-course. For markets, this could be unsettling given the correlation between yields and downturns in 2018. For the dollar, this should be supportive. The odds of an infrastructure deal are good, above 50%, with the key risk being a Democratic House focused on impeaching Trump. Such a bill would augur even higher levels of fiscal spending through 2020, possibly prolonging the business cycle, and setting up an even wider budget deficit when the next recession hits (Chart 5). Chart 5Pro-Cyclical Policy Has To Continue Pro-Cyclical Policy Has To Continue Pro-Cyclical Policy Has To Continue Meanwhile, the shellacking in the Midwest ought to embolden the president to go even harder against China on trade. Rather than the upcoming Xi-Trump meeting in Buenos Aires, the key bellwether of this thesis is whether Trump signals afterwards that he will implement the tariff rate hike on January 1, 2019 (and whether he announces a third round of tariffs). Bottom Line: Go long building products and construction material stocks. Stay short China-exposed S&P 500 companies. The 10-year yield may end the year even closer to 3.5% when the market realizes that the odds of an infrastructure deal are higher than previously thought. The political path of least resistance in the U.S. continues to point towards greater profligacy. Trump Is Aware Of His Constraints In The Middle East Throughout 2018, we have flagged U.S.-Iran tensions as the risk for 2019. In early October, we went long Brent / short S&P 500 as a hedge against this risk, a trade that we closed for a 6% gain last week. During our meetings with clients this quarter, however, several astute observers pointed out that in our own analyses we have stressed the geopolitical and political constraints to President Trump. First, we have argued that the original 2015 nuclear deal signed by President Obama had a deep geopolitical logic, allowing the U.S. to pivot to Asia and stare down China by geopolitically deleveraging the U.S. from the Middle East. If President Trump undermined the détente with Iran, he would be opening up a two-front conflict with both China and Iran, diluting his administration's focus and capabilities. Second, we noted that a rise in oil prices could precipitate an early recession and push up gasoline prices in 2019, a probable death knell for any president's re-election prospects. Our clients were right to ask: Why would President Trump face down these constraints, given the high cost that he would incur? We did not have a very good answer to this question. It is difficult to understand President Trump's preferences for raising tensions against Iran beyond the fact that he promised to do so in his campaign, appears to want to undermine all of President Obama's policies, and turned to Iran hawks to head his foreign policy. Are these preferences worth the risk of a recession in 2019? Or worth the risk of triggering yet another military conflict in the Middle East over a country that only 7% of Americans consider is the 'greatest enemy' (Chart 6)? Chart 6Americans Don't Perceive Iran As 'The Greatest Enemy' Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing Given that the administration has offered exemptions to the oil embargo to eight key importers, it now appears that President Trump is well aware of his geopolitical and domestic constraints. The combined imports of Iranian oil by these eight states is ~1.4mm b/d. While we do not have the detail of the volumes that will be allowed under the waivers, it is likely that these Iranian sales will recover some of the ~1mm b/d of exports lost already (Chart 7). Chart 7Waivers Will Restore Iranian Exports For 180 Days Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing What does this mean for investors? On one hand, it means that the risk of oil prices spiking north of $100 per barrel have substantively decreased. On the other hand, however, it also means that the Trump administration agrees with BCA's Commodity & Energy Strategy view that oil markets remain tight and that OPEC 2.0's spare capacity may be a constraint to future production increases. Bottom Line: The risks of an oil-price-shock-induced 2019 recession have fallen. However, oil prices may yet surge in 2019 to the $85-95 level (Brent) on the back of supply risks in Venezuela and Iran, especially if Saudi Arabia and Russia prove unable to expand production much beyond their current levels. Most of our clients in the Middle East shared the skepticism of our commodity strategists that Saudi Arabia would be able to increase production much higher than current levels in 2019. However, the view was not unanimous. Risks Of Saudi Arabia Going Rogue Have Declined Clients in the Middle East were convinced that the murder of journalist Jamal Khashoggi would have no impact on Saudi oil production decisions. However, the insight from the region is that the incident has probably ended the "blank cheque" that the Trump administration initially gave Riyadh on foreign policy. For global investors, this may not have a major impact. But it may have been at least part of the administration's reasoning behind giving embargo exemptions to such a large number of economies. The incident has likely forced Saudi Arabia to adjust its calculus on three issues: Qatar: The Saudi-Qatari split never made much sense in the first place. It was initially endorsed by President Trump, who may not have understood the strategic value of Qatar to the United States. Defense Secretary James Mattis almost immediately responded by reaffirming the U.S. commitment to the Persian Gulf country which hosts one of the most strategic U.S. air bases in the world. Yemen: The U.S. has now openly called on Saudi Arabia to end its military operations in Yemen. We would expect Riyadh to acquiesce to the request. Iran: With the U.S. giving major importers of Iranian oil exemptions, the message is twofold. First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output. Could Saudi Arabia break with the U.S.? Not a chance. The U.S. is the Saudis' security guarantor. As such, it is up to Saudi Arabia to acquiesce to American foreign policy goals, not the other way around. While we think that President Trump ultimately succumbed to geopolitical and political constraints when he decided to take the "phoney war" approach to Iran, he may have been nudged in that direction by Khashoggi's tragic murder. Bottom Line: A major risk for investors in 2019 was that the Trump administration would treat Saudi preferences for a major confrontation with Iran as its own interests. Such a strategy would have destabilized the global oil markets and potentially have unwound the 2015 U.S.-Iran détente that has allowed the U.S. to focus on China. However, the death of Khashoggi has marginally hurt President Trump domestically - given that it makes him look soft on Saudi Arabia, an unpopular stance in the U.S. Moreover, the administration has come to grips with the risks of a dire oil shock should Iran retaliate. The shift in U.S. policy vis-à-vis Saudi Arabia will therefore refocus the Trump administration on its own priorities, not that of its ally in the Middle East. Trade War Is All About CNY/USD In The Short Term... Clients in Australia and New Zealand are the most sophisticated Western investors when it comes to China. The level of macro understanding of the Chinese economy and the markets in these two countries is unparalleled (outside of China itself, of course). We therefore always appreciate the insights we pick up from our clients Down Under. And they are convinced that the massive capital outflow from China has clearly ceased. The flow of Chinese capital into Auckland, Melbourne, and Sydney real estate has definitely slowed, and anecdotal evidence appears to be showing up in the price data (Chart 8). Separately, this intel has been confirmed by clients from British Columbia and California. Chart 8Pacific Rim Home Prices Rolling Over Pacific Rim Home Prices Rolling Over Pacific Rim Home Prices Rolling Over The reality is that China has successfully closed its capital account. How else can we explain that a 4.7% CNY/USD depreciation in 2015 precipitated a $483 billion outflow of forex reserves, whereas a 10.1% depreciation this year has not had a major impact (Chart 9)? Chart 9On Balance, China Is Experiencing Modest Outflows Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing To be fair, forex reserves declined by $34bn in October, but that is still a far cry from the panic in 2015. Our other indicators suggest that the impact on capital seepage is muted this time around, largely due to the official crackdown on various forms of capital outflows: Quarterly data (Chart 10) reflecting the change in foreign exchange reserves minus the sum of the current account balance and FDI, indicate that while net inflows have remained negative, they are still a far cry from 2015 levels. Chart 10Far Cry From 2016 Crisis Far Cry From 2016 Crisis Far Cry From 2016 Crisis Import data (Chart 11) no longer show the massive deviation between Chinese national statistics and IMF figures. Imports from Hong Kong (Chart 12), specifically, are now down to normal levels, with the fake invoicing problem having quieted down for now. Chart 11No More Confusion Regarding Imports No More Confusion Regarding Imports No More Confusion Regarding Imports Chart 12Fake Invoicing Has Been Curbed Fake Invoicing Has Been Curbed Fake Invoicing Has Been Curbed Growth rate of foreign reserves (Chart 13) is not clearly contracting yet, and has been positive this year. Chart 13Severe FX Reserve Drawdown Has Ended Severe FX Reserve Drawdown Has Ended Severe FX Reserve Drawdown Has Ended Chinese foreign borrowing (Chart 14) is down from stratospheric levels, which limits the volume of potential outflows. Chart 14China's Foreign Lending Has Eased China's Foreign Lending Has Eased China's Foreign Lending Has Eased And the orgy of M&A and investment deals in the U.S. (Chart 15) has ended. Chart 15M&A Deals Have Eased Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing Bottom Line: Anecdotal and official data suggest that capital outflows are in check despite their recent uptick. This could embolden Chinese leaders to continue using CNY/USD depreciation as their primary weapon against President Trump's tariffs, especially if the global backdrop is not collapsing. An increase of the 10% tariff rate to 25% on January 1 could, therefore, precipitate further weakness in the CNY/USD. The announcement of a third round of tariffs covering the remainder of Chinese imports could do the same. This would be negative for global risk assets, particularly EM equities and currencies. ... In the Long Term, Bifurcated Capitalism Our annual pilgrimage to Oceania included our traditional meeting with The Smartest Man In Oceania The Bloke From Down Under.2 He shares our belief that the long-term result of the broader Sino-American geopolitical conflict will be a form of Bifurcated Capitalism. His exact words were that "countries may soon have to choose between being in the Amazon or Alibaba camp," a great real-world implication of our mega-theme. Australian and New Zealand clients are particularly sensitive to the idea that the world may soon be split into spheres of influence because both countries are so high-beta to China, while obviously retaining their membership card in the West. Our suspicion is that both will be fine as they export mainly a high-grade and diversified range of commodities to China. Short of war, it is unlikely that the U.S. will one day demand that New Zealand stop its dairy exports to China, or that Australia stop iron ore and LNG exports. Countries exporting semiconductors to China, on the other hand, could face a choice between enforcing a future embargo or incurring the wrath of their closest military ally. The Bloke From Down Under has pointed out that, given China's dependency on semiconductor technology, a U.S. embargo of this critical tech could be comparable to the U.S. oil embargo against Japan that precipitated the latter's attack on Pearl Harbor. Chart 16China Accounts For 60% Of Global Semiconductor Demand Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing The global semiconductor market reached $354 billion in 2016, with China accounting for 60% of total consumption (Chart 16). Despite the country's insatiable appetite for semiconductors, no Chinese firm is among the world's top 20 makers. This is why Beijing's "Made in China 2025" plan has focused so much on semiconductor capability (Chart 17). The goal is for China to become self-sufficient in semiconductors, gaining 35% share of the global design market. Chart 17China's High-Tech Protectionism Insights From The Road - Constraints And Investing Insights From The Road - Constraints And Investing A key feature of Bifurcated Capitalism will be impairment of investment in high-tech that has dual-use applications in military. Semiconductors obviously make that list. Another key feature would be investment restrictions in such high-tech sectors, particularly the kind of investments and M&A deals that China has been looking for in the U.S. this decade. Further, clients in California are very concerned about the U.S.'s proposed export controls, which would cut off access to China and wreak havoc on the industry. The Trump administration has already signalled that it will restrict Chinese inbound investment. Congress passed, with a large bipartisan majority, an expanded review system, the Foreign Investment Risk Review Modernization Act (FIRRMA). The law has expanded the purview of the Committee on Foreign Investment in the United States (CFIUS), a secretive interagency panel nominally under control of the Treasury Department that can block inbound investment on national security grounds. CFIUS, at its core, has always been an entity focused on China. While the Treasury Department initially signalled it would take as much as 18 months to adopt the new FIRRMA rules, Secretary Mnuchin has accelerated the process. The procedure now will expand review from only large-stake takeovers to joint ventures and smaller investments by foreigners, particularly in technology deemed critical for national security reasons. This oversight began on November 10 and will allow CFIUS to block foreigners from taking a stake in a business making sensitive technology even if it gives the foreign investors merely a board seat. Countries of "special concern" will inherently receive heightened scrutiny, and a country's history of compliance with U.S. law, as well as cybersecurity and American citizens' privacy, will be considerations. A new interagency process led by the Commerce Department will focus on refurbishing export controls so as to protect "emerging and foundational technologies." Such impediments to capital flows are likely to become endemic and expand beyond the U.S. We may be seeing the first steps in the Bifurcated Capitalism concept that one day comes to dominate the global economy. Entire countries and sectors may become off-limits to Western investors and vice-versa for Chinese market participants. At the very least, companies whose revenue growth is currently slated to come from expansion in overseas markets may see those expectations falter. At its most pessimistic, however, Bifurcated Capitalism may precipitate geopolitical conflict if it denies China or the U.S. critical technology or commodities. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see David Shepardson, "Democrats to push for big infrastructure bill with 'real money' in 2019," Reuters, dated November 7, 2018, available at reuters.com. 2 At the time of publication, the said investor was unable to secure the permission of his wife for the "The Smartest Man" moniker. Geopolitical Calendar

Highlights Falling Oil Prices & Bond Yields: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. ECB Corporate Bond Purchases: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days in this cycle for European corporate credit are behind us, as the ECB will not treat its corporate bond purchases any differently than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade & high-yield. Feature Are Falling Oil Prices Telling Us Something About Global Growth? Thus far in November, global financial markets have reversed some of the steep losses incurred during the "Red October" correction. This has occurred for U.S. equities (the S&P 500 fell -8% last month but has risen +4% so far this month), U.S. corporate bonds (high-yield spreads widened +71bps last month and have tightened -19bps this month) and emerging market hard currency debt (USD-denominated sovereign spreads widened +27bps last month and have tightened -9bps this month). One market that has not rebounded, however, is oil. The benchmark Brent oil price fell -11% in October, but has fallen another -7% in November. This has been enough to nearly wipe out the entire +20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil markets in recent years. Such a large decline in the oil price as has been seen of late would typically result in sharp drop in government bond yields, driven by falling inflation expectations. That correlation has been holding up in the major economies outside the U.S., where nominal yields and inflation expectations are lower than the levels seen before the October peak in oil prices. Nominal U.S. Treasury yields, by contrast, remain resilient, despite the fall in TIPS breakevens (Chart of the Week). This is because real Treasury yields have been climbing higher as investors acquiesce to the steady hawkish message from the Fed by making upward revisions to the expected path of U.S. policy rates. Chart of the WeekShifting Correlations Shifting Correlations Shifting Correlations The biggest impediment holding back a full recovery of the October losses for global risk assets is uncertainty over the global growth outlook. While the U.S. economy continues to churn along at an above-trend pace, there are signs that tighter monetary policy is starting to have an impact. Both housing and capital spending have cooled, although not yet by enough to pose a terminal threat to the current long business cycle expansion. The outlook for growth outside the U.S. is far more muddled, adding to investor confusion. China has seen a clear growth deceleration throughout 2018, but the recent reads from imports and the Li Keqiang index suggest that growth may be stabilizing or even modestly re-accelerating (Chart 2). Our China strategists are not convinced that this is anything more than a ramping up of imports and production in advance of the full imposition of U.S. trade tariffs, especially with Chinese policymakers reluctant to deploy significant fiscal or monetary stimulus to boost growth. Chart 2Mixed Messages On Growth Mixed Messages On Growth Mixed Messages On Growth A similar mixed read is evident in overall global trade data. World import growth has also slowed throughout 2018, but has shown some stabilization of late (second panel). A similar pattern can be seen in capital goods imports within the major developed economies. Our global leading economic indicator (LEI) continues to contract, but the pace of the decline has been moderating and our global LEI diffusion index - which measures the number of countries with a rising LEI versus those with a falling LEI - may be bottoming out (third panel). There are also large, and growing, divergences within the major developed economies. The manufacturing purchasing managers' indices (PMIs) for the euro area and the U.K. have been falling steadily since the start of the year, but the PMIs have recently ticked up in the U.S. and Japan (Chart 3). A similar pattern can be seen in the OECD LEIs, which have retreated from the latest cyclical peaks by far more in the U.K. (-1.6%) and euro area (-1.2%) than in the U.S. (-0.3%) and Japan (-0.6%). Chart 3Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields With such mixed messages from the macro data, investors understandably lack conviction. The backdrop does not look soft enough yet to threaten global profit growth and justify sharply lower equity prices and wider corporate bond spreads. Yet the growth divergences between the U.S. and the rest of the world are intensifying, creating a backdrop of rising U.S. real interest rates and a stronger U.S. dollar. That combination is typically toxic for emerging markets, but the impact of that would be muted this time if China were to indeed see a genuine growth reacceleration. This macro backdrop lines up with our current major fixed income investment recommendations. We suggest only a neutral allocation to global corporate bonds given the uncertainty over growth, but favoring the U.S. over Europe and emerging markets given the clearer evidence of a strong U.S. economy. At the same time, we continue to recommend below-benchmark overall portfolio duration exposure, but with regional allocations favoring countries where central banks will have difficulty raising interest rates (Japan, Australia, core Europe, the U.K.) versus nations where policymakers are likely to tighten monetary policy (U.S., Canada). However, the latest dip in oil should not be ignored. A more sustained breakdown of oil prices could force us to downgrade corporate bonds and raise duration exposure - if it were a sign that global growth was slowing and inflation expectations had peaked. The current pullback in oil has occurred alongside a decelerating trend in global economic data surprises, after speculators had ramped up long positions in oil and prices were stretched relative to the 200-day moving average (Chart 4). This suggests that the latest move has been corrective, and not a change in trend, although the burden of proof now falls on the evolution of global growth, both in absolute terms and relative to investor expectations. Chart 4Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Bottom Line: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. European Corporates Are About To Lose A Major Buyer Last week, we published a Special Report discussing the ECB's options at next month's critical monetary policy meeting.1 One of our conclusions was that the central bank will deliver on its commitment to end the new purchases phase of its Asset Purchase Program (APP) at year-end. The bulk of the assets in the APP are government bonds, but the ECB has also been buying corporate debt in the APP since June 2016. The ECB is set to end those purchases at the end of December, to the likely detriment of euro area corporate bond returns. The Corporate Sector Purchase Program (CSPP), as it is formally known, has been a targeted tool used by the ECB to ease financial conditions for euro area companies. This has occurred through three main channels: tighter corporate bond spreads, greater access for companies to issue debt in the corporate primary market, and increased bank lending to non-financial corporations. The CSPP was intended to complement the ECB's other monetary stimulus measures, like negative interest rates and the buying of government debt. The first CSPP purchases were made on June 8, 2016. The euro area corporate bond market responded as expected, with investment grade spreads tightening from 128bps to 86bps by the end of 2017. There were spillovers into high-yield bonds, as well, with spreads falling -129bps over the same period (Chart 5). Since then, however, spreads have steadily widened and European corporates have underperformed their U.S. equivalents. This suggests that some of the relative performance of euro area credit may have simply reflected the relative strength of the euro area economy compared to the U.S. The greater acceleration of euro area growth in 2017 helped euro area corporates outperform U.S. equivalents, while the opposite has held true in 2018. Chart 5ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads The CSPP has operated with a defined set of rules governing the purchases. Bank debt was excluded, as were bonds rated below investment grade. Only debt issued by corporations established in the euro area were eligible for the CSPP, although bonds from euro-based companies with parents who were not based in the euro area were also eligible. The latest update on the holdings data from the ECB shows that there are just under 1,200 bonds in the CSPP portfolio. Yet despite the ECB's best efforts to maintain some degree of portfolio diversification, the impact of the CSPP on euro area corporate bond markets was fairly consistent across countries and sectors (Chart 6). Italy is the notable diverging country this year, as the rising risk premiums on all Italian financial assets have pushed corporate bond yields and spreads well above the levels seen in core Europe, even with the ECB owning some Italian names in the CSPP. Chart 6Spread Convergence During CSPP Spread Convergence During CSPP Spread Convergence During CSPP There was also convergence of yields and spreads among credit tiers during the first eighteen months of the CSPP, with valuations on BBB-rated debt falling towards the levels on AA-rated and A-rated bonds (Chart 7). That convergence has gone into reverse in 2018, with BBB-rated spreads widening by +55bps year-to-date (this compares to a smaller +25bps increase in U.S. BBB-rated corporate spreads). A surge in the available supply of BBB-rated euro area bonds is a likely factor in that spread widening, as evidenced by the sharp rise in the market capitalization of the BBB segment of the Bloomberg Barclays euro area corporate bond index (top panel). Chart 7A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? More broadly, the CSPP has helped the ECB's goal of boosting the ability of European companies to issue debt in primary bond markets. Traditionally, European firms have used bank loans as their main source of borrowed funds, with only the largest firms being able to issue debt in credit markets. That has changed during the CSPP era. According to data from the ECB, gross debt issuance by euro area non-financial companies (NFCs) has risen by €104bn since the start of the CSPP, taking issuance back to levels not seen since 2014 (Chart 8). The bulk of the issuance has been in shorter-maturity bonds, but there has been a notable increase in the issuance of longer-dated debt since the CSPP began. Chart 8Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding The ECB's role as a marginal buyer of bonds in the primary, or newly-issued, market has helped boost that gross issuance figure. The share of bonds that the ECB owns in the CSPP that was issued in the primary market has gone from 6% soon after the CSPP started to the current 18% (Chart 9). The growth in euro area non-financial corporate debt went from 6% to over 10% during the peak of the CSPP buying between mid-2016 and end-2017, but has since decelerated to 7%. At the same time, the annual growth in loans to NFCs, which was essentially zero during the first eighteen months of the CSPP, has accelerated to 2% over the course of 2018. Chart 9More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance In other words, euro area companies had been substituting bank financing for bond financing in the CSPP "era", but have since shifted back towards bank loans in 2018. That shift in financing was most notable among CSPP-eligible companies, particularly those smaller firms that had not be able to issue debt in the primary market pre-CSPP, according to an ECB analysis conducted earlier this year.2 From the point of view of the investible euro area corporate bond market, however, even larger companies that have done that shift in bank financing to bond financing have seen no noticeable increase in aggregate corporate leverage. In Chart 10, we show our bottom-up version of our Corporate Health Monitor (CHM) for the euro area. This indicator is designed to measure the aggregate financial health of euro area companies using financial ratios incorporating actual data from individual companies. We separated out the list of companies used in that CHM that are currently held in the CSPP portfolio and created a "CSPP-only" version of the CHM (the blue lines in all panels). All issuers that were eligible for inclusion in the CSPP, but whose bonds were not actually purchased by the ECB, are used to create a "non-CSPP" CHM (the black dotted lines). Chart 10No Fundamental Changes From CSPP No Fundamental Changes From CSPP No Fundamental Changes From CSPP As can be seen in the chart, there is no material difference in any of the ratios for bonds within or outside the CSPP. The one notable exception is short-term liquidity, where the ratios were much lower for names purchased by the ECB than for those that were not. This lends credence to the idea that the CSPP most helped firms that were more liquidity-constrained, likely smaller companies. The biggest change in any of the ratios has been in interest coverage, but that has been for both CSPP and non-CSPP issuers, suggesting a common factor outside of ECB buying - zero/negative ECB policy rates, ECB purchases of government bonds that helped reduce all European borrowing rates - has been the main driver of lowering interest costs. Looking ahead, the ECB is likely to stop the net new purchases of its CSPP program when it does the same for the full APP next month. All of which is occurring for the same reason - the euro area economy is deemed by the central bank to no longer need the support of large-scale asset purchases given a full employment labor market and gently rising inflation. As we discussed in our Special Report last week, the ECB has other options available to them if there is a reduction in euro area banks' capacity or willingness to lend, such as introducing a new Targeted Long-Term Refinancing Operation (TLTRO). Continuing with unconventional measures involving direct ECB involvement in financial markets, like buying corporate debt, is no longer necessary. Our euro area CHM suggests that there are no major problems with European corporate health that require a wider credit risk premium. We still have our reservations, however, about recommending significant euro area corporate bond exposure while the ECB is set to end its asset purchase program. New buyers will certainly come in to replace the lost demand from the elimination of CSPP purchases, but private investors will likely require higher yields and spreads than the central bank - especially if the current period of slowing euro area growth were to continue. Bottom Line: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days for European corporate debt for the current cycle are behind us, as the ECB will not treat its corporate bond purchases any different than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade and high-yield. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Evaluating The ECB's Options In December", dated November 6th 2018, available at gfis.bcareserach.com and fes.bcaresearch.com. 2 The ECB report on its CSPP program was published in the March 2018 edition of the ECB Economic Bulletin, which can be found here. https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201804.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stubbornly Resilient Bond Yields Stubbornly Resilient Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Equities had a wild ride in October, ... : The S&P 500 has bounced smartly off of its October 29th lows, but the decline that preceded the bounce was unusually severe. ... that unsettled a lot of investors, and made us reconsider our constructive take on risk assets: To judge by the November 5th Barron's, and some client conversations, several technically-minded investors are unconvinced by the bounce. Nothing has changed with our equity downgrade checklist, however, ... : The fundamental picture hasn't changed at all - neither corporate revenues nor margins appear to be in any immediate difficulty; though we still expect inflation to surprise to the upside, the latest data will not push the Fed to speed up its gradual rate-hike pace; and the combination of blockbuster third-quarter earnings and October's selloff made valuations more reasonable. ... so we see no reason to downgrade equities now, though we do have the admonition of a Wall Street legend ringing in our ears: If the fundamental backdrop remained unchanged, we would be inclined to upgrade equities if the S&P 500 got back to the 2,600-2,640 range, even though we are operating with a heightened sense of vigilance befitting the lateness of the hour. Feature It has been just four weeks since we rolled out our equity downgrade checklist. We would not ordinarily devote an entire Weekly Report to reviewing all of its components, but the last four weeks have hardly been ordinary. The swiftness of the decline, and the apparent lateness of the cycle, have unsettled investors enough to make several of them reconsider just how long they want to stay at the bull-market party. At times when market action provokes emotional gut checks, it is essential for investors to have a process to fall back on. Process provides a rational, objective haven from noise and emotion, and should help foster better decision-making. Our commitment to process underpins our fondness for checklists. They will never be comprehensive - as usual, we have our minds on other important inputs - but they help to ground our thinking, and we're happy to have them when markets make wild swings. Has The Recession Timetable Speeded Up? We are not interested in recessions for their own sake - we'll let the NBER's Business Cycle Dating Committee tell us when recessions begin and end, several months after the fact - but they're poison for risk assets. Any asset allocator who can recognize them in a timely fashion has a leg up on outperforming the competition. We therefore have been repeatedly monitoring the individual components of our recession indicator (Table 1). They do not betray any more concern than they did four weeks ago. Table 1Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist The yield curve is clearly flattening, just as one would expect as the Fed gets further into a rate-hiking campaign, but it is still a comfortable distance from inverting (Chart 1). We think yields at the long end have a way to go before they stop rising, so we expect the fed funds rate will have to get well into the 3's before the 3-month bill rate can overtake the 10-year Treasury yield. The Conference Board's Leading Economic Indicator is still expanding at a robust clip (Chart 2). Finally, we estimate the fed funds rate is about a year away from exceeding the equilibrium rate, thus signaling that policy has turned restrictive. Chart 1The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... Chart 2... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging The unemployment rate continues to fall. Reversing the trend so that the three-month moving average could back up by the third of a percentage point that has unfailingly accompanied recessions (Chart 3) would require net monthly payroll additions to crater. Assuming annual population growth of 1%, and a constant labor force participation rate, net monthly job gains would have to fall to 100,000 for the three-month moving average to back up to 4% in 2020; if the pace of gains merely held at 120,000, the unemployment recession signal wouldn't be issued until 2021 (Chart 4). We applied the same conditions to the Atlanta Fed's online unemployment calculator to see what it would take for the unemployment rate to cross into the danger zone in 2019 (Table 2). Since the seven-year trend of 200,000 monthly net payroll additions would have to reverse on a dime for unemployment to issue a near-term warning, we do not foresee checking this box anytime soon. Chart 3Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Chart 4... But None Is Forthcoming ... ... But None Is Forthcoming ... ... But None Is Forthcoming ... Table 2... Unless Hiring Falls Off A Cliff Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Are Corporate Earnings Coming Under Pressure? As we mentioned last week, we view the labor market as tight and getting tighter. We thereby expect that wages are on their way to rising enough to crimp corporate margins, albeit slowly. The composite employment cost index has been in an uptrend since 2016, but it ticked lower last month, and remains well below its cyclical highs ahead of the last two recessions (Chart 5). Chart 5Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages October's global upheaval was good for the safe-haven dollar, which surged to a new year-to-date high (Chart 6). The DXY dollar index is now within 3% of the 100 level that would lead us to check the dollar strength box. Even though we're not checking the box yet, the dollar's 10% advance since mid-February will exert a modest drag on S&P 500 earnings for the next few quarters. Triple-B corporate yields have ticked a little higher since we rolled out the checklist, extending their six-year highs (Chart 7), though we still view them as manageable. Chart 6A Gentle Headwind (For Now) A Gentle Headwind (For Now) A Gentle Headwind (For Now) Chart 7Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet A rising savings rate would cancel out some of the top-line benefits from employment gains. It fell pretty sharply in the third quarter, however, amplifying the self-reinforcing effect of new hiring. It's at the bottom of the range that's prevailed since 2014 (Chart 8), but could go still lower if consumption tracks the robust consumer confidence readings, as it consistently has in the past. Chart 8Consumers Are Well-Fortified Consumers Are Well-Fortified Consumers Are Well-Fortified EM economies have become considerably more indebted since the crisis, as developed-world savings sought an outlet; corporate profits are falling; and a stronger dollar makes it harder for EM borrowers to service their USD-denominated debt. A credit crisis (or multiple credit crises) could slow global activity enough to pressure multinationals' earnings, even if the U.S. economy is mostly insulated from EM wobbles. EM equities have gotten a respite since global equities put in their year-to-date lows, and Chinese stimulus could extend EM economies a lifeline, though BCA expects that Beijing will disappoint investors hoping for a meaningful boost. We remain bearish on emerging markets as a firm, but EM distress is not anywhere near acute enough to justify ticking the box. Is Inflation Starting To Make The Fed Uneasy? There are two channels by which inflation could pose a problem for equities. The first is the Fed: if it is discomfited by what it sees in realized inflation, or perceives that inflation expectations could become unanchored, it is likely to move forcefully to quash upward pressure on prices. A forceful pace is considerably faster than a gradual pace, and would bring forward a monetary policy inflection. If policy flips from accommodative to restrictive sooner than we expect, the window for risk-asset outperformance will shrink. With all of its talk about symmetric inflation targets, the FOMC has made it clear that it will not make any attempt to defend its 2% core PCE inflation target. It is comfortable with an overshoot, and has indeed openly wished for one for much of the post-crisis era. There are limits to its indulgence, however, and we suspect that the Fed would not be comfortable if core PCE inflation were to make a new 20-year high above 2.5%. With that red line far off (Chart 9), inflation is not yet likely to encourage the Fed to quicken the pace at which it removes accommodation. Chart 9Turtles, Sloths And Inflation Turtles, Sloths And Inflation Turtles, Sloths And Inflation Inflation expectations aren't yet pressing the Fed to speed things up, either. Long-maturity TIPS break-evens have retreated slightly since mid-October, and have yet to enter the range consistent with the 2% inflation target (Chart 10). The media and the broad mass of investors don't bother with symmetric targets, or implied break-evens; they take their cues from consumer prices. A multiple haircut driven by popular inflation fears is the second channel by which inflation could halt the equity advance, but CPI remains well below the mid-3% levels that would provoke concern (Chart 11). Chart 10Stubbornly Well-Anchored Stubbornly Well-Anchored Stubbornly Well-Anchored Chart 11No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet So What's To Worry About? Irrational exuberance is always a concern after an extended period of gains, but there's no sign of it in broad market measures right now. Blockbuster earnings gains have pulled the S&P 500's forward P/E multiple back down to the 15s from its January peak above 18. Secondary measures like price-to-sales, price-to-book, and price-to-cash-flow are well below extreme levels in the aggregate. If the S&P 500 is going to get silly, it will have to surge first. That said, the latter stages of bull markets and expansions can be perilous, and we are on high alert. We continue to actively seek out any evidence that challenges our broadly constructive take on risk assets and the U.S. economy. Though we have yet to find anything compelling, an admonition from legendary technical analyst and strategist Bob Farrell has lodged in our mind. Rule number nine of Farrell's ten market rules to remember states, "When all the experts and forecasts agree - something else is going to happen." It's much more fun to bring novel views and analysis to our clients, but we don't get overly concerned about agreeing with investor consensus. It's inevitable that a lot of people will agree in the middle of extended cycles; we simply strive to be among the first to recognize the major macro inflection points and determine the optimal asset-allocation framework to benefit from them. We get a little antsy, though, when everyone knows that something is either certain to happen, or cannot happen by any stretch of the imagination. The near-unanimity with which the investment community believes that a recession cannot begin in 2019 is increasingly eating at us. We have been checking and re-checking the data, and checking and re-checking our colleagues' various models, in search of trouble, but to no avail. Even though recessions begin at economic peaks, and the economy nearly always appears to be in fine fettle when the downturn asserts itself, the sizable fiscal thrust on tap for 2019 seems to obviate the possibility of a contraction. When discussing potential risks in face-to-face meetings with clients this week, we most often cited trade tensions, as any material rollback of globalization would erode corporate profit margins and would strike at global trade, on which much of the rest of world's economies rely. A dramatic worsening of the trade picture is not our base case, but we do expect upside surprises in inflation, and an attendant upside surprise in the terminal fed funds rate. We have been considering that view mainly from the perspective of fixed-income positioning: underweight Treasuries and maintain below-benchmark duration. We also have been assuming that the FOMC would lift the fed funds rate to 3.5% at the end of 2019 via four quarter-point rate hikes, and possibly take it all the way to 4% in the first half of 2020. If it were to speed up its pace, and take the fed funds rate to 3.5% by the middle of next year, and 4% by the end, we believe financial conditions would tighten enough to choke off the expansion. Monetary policy impacts the economy with a lag, so a recession may still not begin until 2020 in that scenario, but we'd bet that an equity bear market would begin in 2019. Investment Implications Balanced investors should maintain at least an equal weight position in equities. Although our checklist is a downgrade checklist, we're alert to opportunities to upgrade as well as downgrade. As we first wrote one week before the October selloff ended, we would look to overweight equities if the S&P 500 were to dip back into the 2,600-2,640 range (Chart 12). If U.S. equities wobble again in line with our Global Investment Strategy team's MacroQuant model's near-term discomfort, investors may get another opportunity before the year is out. Chart 12Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

As is tradition, during client visits in Europe last week, I had the pleasure of reconnecting with Ms. Mea, a long-term BCA client.1 It was our third encounter and, as always, Ms. Mea was eager to delve into our reasoning, challenge our views and strategy, as well as gauge our conviction level. We devote this week's report to key parts of our dialogue. I hope clients find it insightful and beneficial. Ms. Mea: Isn't the EM selloff and underperformance already overextended? I am afraid you will overstay your negative view on EM risk assets as happened in 2016. What are you watching to ensure you alter your stance as and when appropriate? Answer: I am very cognizant of not overstaying my negative stance on EM. I viewed the EM/China rally from their 2016 lows as a mid-cycle outperformance in a structural downtrend.2 Consequently, I argued the rally was not sustainable and that it was a matter of time before EMs and China-plays entered into a new bear market. Barring perfect timing, it was difficult to make money during that rally. Investors who averaged in EM stocks and local bonds over the past three years (including late 2015/early 2016 lows) and did not sell early this year have not made money. The current down-leg in EM financial markets may be the last phase of the bear market/underperformance that began in 2011, and it will eventually create a major buying opportunity. That said, this bear market will likely last much longer and be larger in magnitude than many investors expect. In the recent report titled EMs Are In A Bear Market, I elaborated on why this is a bear market and not just a correction. We also discussed how much further it might go.3 Big-picture macro themes - such as China/EM credit excesses and misallocation of capital - have informed my core views in recent years. Notwithstanding, I am watching various market signals that often lead economic data and are typically early in signaling a reversal in financial markets. Just a few examples of market signals and indicators I am following closely: Turns in EM corporate bond yields often coincide with reversals in EM stocks. For now, EM corporate bond yields are rising, and hence they do not signal a bottom in EM share prices (Chart I-1, top panel). Chart I-1EM/Asian Corporate Bonds Signal Downside Risks To Share Prices EM/Asian Corporate Bonds Signal Downside Risks To Share Prices EM/Asian Corporate Bonds Signal Downside Risks To Share Prices The same holds true for Emerging Asian markets: surging corporate bond yields are heralding further declines in Asian share prices (Chart I-1, bottom panel). Our Risk-on versus Safe-Haven (RSH) currency ratio positively correlates with EM equity prices. The RSH ratio has recently rebounded but has not broken above its 200-day moving average (Chart I-2). Hence, there is no meaningful buy signal as of yet. Chart I-2Our Market Risk Indicator bca.ems_wr_2018_11_08_s1_c2 bca.ems_wr_2018_11_08_s1_c2 The annual rate of change of this indicator leads the global trade cycles and entails further slowdown in global trade (Chart I-3). Chart I-3Global Trade Slowdown Is Not Over bca.ems_wr_2018_11_08_s1_c3 bca.ems_wr_2018_11_08_s1_c3 Finally, a number of EM equity indexes - small-caps and an equal-weighted index - have broken below their 3-year moving averages (Chart I-4). This entails that the selloff in EM stocks is very broad-based. It could also entail that the overall EM index will likely break below its 3-year moving average as well (Chart I-4, bottom panel). Chart I-4EM Equity Selloff Has Been Broad-Based EM Equity Selloff Has Been Broad-Based EM Equity Selloff Has Been Broad-Based Apart from market signals, I am also monitoring economic data, and so far, there are few signs of a revival in global trade or EM growth. The EM manufacturing PMI is falling (Chart I-5, top panel). Manufacturing output growth in Asia and Germany are decelerating sharply (Chart I-5, bottom panel). When global trade growth underwhelms, EM risk assets and currencies fare poorly. Chart I-5Global Growth And EM Credit Spreads Global Growth And EM Credit Spreads Global Growth And EM Credit Spreads Remarkably, both panels of Chart I-5 corroborate that the key reason for the EM selloff this year has not been the Federal Reserve tightening but the deceleration in global trade. We do not foresee a reversal in global trade and China/EM growth deceleration in the coming months. This heralds maintaining our negative view on EM risk assets and currencies for now. Ms. Mea: It is true that China is slowing, but policymakers are also stimulating and a lot of bad news may already be priced into China-related markets. Why do you believe there is more downside in China-related markets and EM risk assets from today's levels? Answer: Indeed, China is easing policy, but policy stimulus has so far been limited. It also works with a time lag. First, the bottoms in the money and the combined credit and fiscal spending impulses preceded the trough in EM and commodities by 6 months at the bottom in 2015 and by about 15 months at the top in 2017 (Chart I-6). Even if the money as well as credit and fiscal impulses bottom today it could take several more months before the selloff in EM financial markets and commodities prices abates. Chart I-6China: Money, Credit And Fiscal Impulses And Financial Markets bca.ems_wr_2018_11_08_s1_c6 bca.ems_wr_2018_11_08_s1_c6 Second, the stimulus has so far been limited. The recently increased issuance of special bonds by local governments was already part of this year's budget. Simply, it was delayed early this year and has been pushed into the third quarter. In addition, there are reports that 42% of this recent special bond issuance will be used for rural land purchases rather than infrastructure spending.4 The former will not boost economic activity and demand for raw materials and industrial goods. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report5 that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend and borrowers' readiness to borrow) and the velocity of money (marginal propensity to spend among households and companies). On both accounts, odds are that the transmission mechanism will be slower and somewhat impaired this time around than in the past. Chart I-7 illustrates that the marginal propensity to spend/invest by companies is diminishing, and it has historically defined the primary trend in industrial metals prices. Chart I-7China: Companies Are Turning More Cautious On Capex China: Companies Are Turning More Cautious On Capex China: Companies Are Turning More Cautious On Capex Third, most of the fiscal stimulus - tax cuts and income tax deductions - are designed to raise household incomes. This will primarily help spending on some consumer goods and services. Yet, there will be little help for property sales, construction and infrastructure spending. These three types of spending drive most of the demand for commodities, materials and industrial goods. In turn, industrial goods, machinery, commodities and materials account for about 80% of total Chinese imports. Hence, the channels by which China affects the rest of the world are via imports of capital goods, materials and commodities. Overall, China's tax reforms will have little bearing on its imports from other countries. The latter are heavily exposed to the mainland's construction and infrastructure spending, which in turn are driven by the Chinese credit cycle. This is why we spend so much time analyzing mainland money and credit cycles. Finally, the significance of U.S. import tariffs for the Chinese economy should be put into perspective. China's exports to the U.S. make up only 3.6% of its GDP. This compares with the mainland's total exports of 20% and capital spending of 42% of GDP (Chart I-8). Chart I-8What Drives China's Growth What Drives China's Growth What Drives China's Growth Consequently, capital spending is much more important to the Middle Kingdom's growth than its shipments to the U.S. That said, the trade confrontation between the U.S. and China is likely already negatively affecting overall business and consumer confidence in China (Chart I-9). Chart I-9China: Service Sector Is Moderating China: Service Sector Is Moderating China: Service Sector Is Moderating In addition, Chart I-10 illustrates that China's manufacturing PMI for export orders have plunged, signifying an imminent slump in its exports. This could be due to its shipments not only to the U.S. but also to developing economies, which account for a larger share of total exports than shipments to the U.S. and EU combined. Considerable depreciation in EM currencies has made their imports more expensive, dampening their capacity to import. Chart I-10Chinese Exports Are At Risk Chinese Exports Are At Risk Chinese Exports Are At Risk In brief, China's growth will continue to disappoint, weighing on China plays in financial markets. Ms. Mea: Why has strong U.S. growth not helped global trade, China and EM in general? How do U.S. economic and financial markets enter into your analysis about the world and EM? Answer: One common mistake that many commentators make is to form a view on the U.S. growth outlook and then extrapolate it to the rest of the world. The U.S. economy is still the largest, but it is no longer the sole dominant force in the global economy. Chart I-11 shows that U.S. and EU annual imports are equal to $2.5 and $2.2 trillion, respectively. Combined annual imports of China and the rest of EM amount to $6 trillion - hence, they are much larger than the aggregate imports of U.S. and EU. This is why global trade can deviate from time to time from U.S. domestic demand cycles. Chart I-11EM Imports Are Larger Than U.S. And EU Imports Together EM Imports Are Larger Than U.S. And EU Imports Together EM Imports Are Larger Than U.S. And EU Imports Together That said, due to their sheer size, U.S. financial markets have a much larger impact on global markets than U.S. imports do on global trade. EM financial markets are greatly influenced by their counterparts in the U.S. In this respect, we have a few observations: U.S. growth is robust, the labor market is tight and core inflation is rising. Barring a major deflation shock from EM, the path of least resistance for U.S. bond yields and the fed funds rate is up. Continued rate hikes by the Fed constitute a major menace to EM risk assets. For now, the growth divergence between the U.S. and rest of the world will continue to be manifested in a stronger U.S. dollar. This is a bad omen for EMs. Chart I-12A Risk To U.S. Share Prices A Risk To U.S. Share Prices A Risk To U.S. Share Prices Rising U.S. corporate bond yields have historically been associated with lower U.S. share prices, and presently portend a further drop in American equities (Chart I-12). Finally, the surge in equity market leaders - specifically, new economy stocks - has been on par with previous bubbles, as shown in Chart I-13. Chart I-13History Of Financial Bubbles History Of Financial Bubbles History Of Financial Bubbles It is impossible to know whether or not this is a bubble that has already reached its top. But the magnitude and speed of the rally, at minimum, warrant a consolidation phase. On the whole, Fed tightening, rising corporate bond yields, a strong dollar and elevated valuations warrant further correction in U.S. share prices. This will reinforce the downtrend in EM risk assets. Ms. Mea: Are fundamentals in many EM countries not better today than they were amid the taper tantrum in 2013? Specifically, current account balances in many developing nations have improved and their currencies have cheapened. Answer: Your observation is correct - current account deficits have improved and currencies have become much cheaper than before. Nevertheless, these are necessary but not sufficient conditions to turn bullish: First, marginal shifts in balance of payments drive exchange rates. Even though current account deficits are currently smaller and currencies are moderately cheap in many EMs, a deterioration in their current accounts due to weakening exports in general and falling commodities prices in particular will depress their currencies. In this context, China's imports are critical. As they decelerate, EM ex-China's current account balances will deteriorate and their exchange rates will depreciate. Second, current account surpluses do not always preclude currency depreciation. Chart I-14 shows that the Korean won, the Taiwanese dollar and the Malaysian ringgit experienced bouts of depreciation, despite running current account surpluses. Chart I-14Current Account Surpluses And Exchange Rates Current Account Surpluses And Exchange Rates Current Account Surpluses And Exchange Rates Third, emerging Asian currencies are at a risk from another spell of RMB depreciation. Chart I-15 illustrates that CNY/USD exchange rate correlates with the interest rate differential between China and the U.S. As the Fed hikes rates further and the People's Bank of China (PBoC) keep interest rates stable, the yuan will likely depreciate against the greenback. Chart I-15CNY/USD And Interest Rates CNY/USD And Interest Rates CNY/USD And Interest Rates Despite capital controls, it seems the interest rate differential affects the exchange rate in China too. Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. If the authorities push up interest rates to make the yuan attractive to hold, it will hurt the already overleveraged and weak economy. If the PBoC reduces interest rates further to help the real economy, the RMB will come under depreciation pressure. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-worst outcome for the nation. Yet, this will rattle Asian currencies and risk assets. Finally, EM currency valuations are but particularly cheap, except Argentina, Turkey and Mexico as depicted in Chart I-16A & Chart I-16B. When currency valuations are not at an extreme, they usually do not matter for the medium-term outlook. Chart I-16AEM Currency Valuations EM Currency Valuations EM Currency Valuations Chart I-16BEM Currency Valuations EM Currency Valuations EM Currency Valuations As to the EM fixed-income market, exchange rates are the key driver of their performance. Currencies depreciation causes a selloff in high-yielding local currency bonds and typically leads to credit spread widening. The latter occurs because U.S. dollar debt becomes more difficult to service when the value of local currency declines. Besides, EM currencies usually weaken amid a global trade slowdown and falling commodities prices. The latter two undermine issuers' revenues and their capacity to service debt, warranting wider credit spreads. Ms. Mea: What about equity valuations? Aren't they cheap? Chart I-17EM Equity Multiples bca.ems_wr_2018_11_08_s1_c17 bca.ems_wr_2018_11_08_s1_c17 Answer: EM stocks are not very cheap. Our composite valuation indicator based on a 20% trimmed mean of trailing and forward P/Es, PBV, price-to-cash earnings and price-to-dividend ratios denotes a slightly attractive valuation (Chart I-17). According to our cyclically-adjusted P/E ratio, EM equities are also moderately cheap (Chart I-18). Chart I-18EM Equities: Cyclically-Adjusted P/E Ratio EM Equities: Cyclically-Adjusted P/E Ratio EM Equities: Cyclically-Adjusted P/E Ratio In short, EM equity valuations are modestly cheap. As with currencies, however, unless valuations are at an extreme (say, one or two-standard deviations from their mean), they may not matter for a while. Barring extreme over- or undervaluation, share prices are typically driven by profit cycles. Importantly, EM corporate earnings are set to decelerate further and probably contract in the first half of 2019 (Chart I-19). If this scenario transpires, share prices will drop further, regardless of valuations. Chart I-19EM Corporate Earnings Are At Risk EM Corporate Earnings Are At Risk EM Corporate Earnings Are At Risk Ms. Mea: Why don't you write about risks to your view? And, I would like to use this opportunity to ask what are the risks to your view presently? Answer: The basis of why I do not write about the risks to my view is as follows: The risks to a view are often the cases when the key pillars of analysis do not play out. It follows that in these cases, the risks to the view are obvious and there is no need to write about them. To sum up our discussion today, the key pillars of my view are: China's policy stimulus has so far been moderate and the stimulus usually works with a time lag. Additionally, the combination of the regulatory tightening on banks and non-bank financial organizations and the lingering credit and property market excesses in China will generate a growth slowdown that will be longer and deeper than the markets currently expect. The Fed will continue ratcheting up rates as U.S. core inflation is grinding higher. The combination of the above three will produce weaker global growth, a stronger U.S. dollar, and lower commodities prices. All in all, these are bearish for EM risk assets. It is evident that if these themes and assumptions are incorrect, the view will be wrong. Hence, writing that the risks to my view are that my assumptions and themes are mistaken is nothing other than tautology. That said, there are seldom cases when the underlying economic themes and the assumptions are valid, yet the investment recommendations are amiss. These are, in fact, true risks to the view and they are worthy of discussion. Yet, identifying in advance what could go wrong when the analysis and assumption are accurate is very difficult. Presently, I can think of one reason why my investment recommendations could be erroneous even if my economic themes end up being largely valid: It is the shortage of investable assets worldwide relative to capital that is looking to be invested. Quantitative easing programs in the advanced economies have shrunk the size of investable assets. As a result, too much money is chasing too few assets. Consequently, the risk to my view is that EM assets never become sufficiently cheap and that fundamentals do not matter that much. In other words, investors could rush back into EM risk assets despite the poor growth backdrop and not-so-cheap valuations. This is akin to a game of musical chairs where the number of participants is greater than the number of chairs. To complicate things, some chairs are broken, i.e., some assets are of bad quality. As a result, game participants (i.e., investors) are now facing a tough choice between (1) being somewhat prudent and risking being left without a chair; or (2) rushing in and getting either a good chair or a broken chair (depending on luck). Applying this musical chairs analogy, buying EM risk assets at the current juncture is similar to rushing in and hoping to get a good chair. It is a very high-risk bet and success is contingent on luck. In my subjective assessment, there is about a 30% chance that this strategy - buying EM risk now - will be successful with 70% odds favoring being risk averse for the time being. The latter entails staying with a defensive strategy in EM and underweighting/shorting EM versus DM. Ms. Mea: What is your recommended country allocation currently? Answer: In the EM equity space, our overweights are Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia, and central Europe. Our underweights, on the other hand, are India, Indonesia, the Philippines, Hong Kong, South Africa and Peru. Chart I-20 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-20EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. In the currency space, we continue recommending shorting a basket of the following EM currencies versus the dollar: ZAR, IDR, MYR, KRW and CLP. The full list of our country recommendations for equity, local fixed-income, credit and currency markets are available below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Reports, "Where Are EMs In The Cycle?" dated May 3, 2018 and "Ms. Mea Challenges The EMS View," dated October 19, 2018, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018, available at ems.bcaresearch.com. 4 Please see: https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 5 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 25, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The End Of APP?: Economic growth in the euro area has lost momentum, but it is not clear that an extended period of below-trend growth is unfolding. With most measures of spare capacity showing a lack of it, the ECB must still move forward with its plans to begin removing policy accommodation. Policy Choices: If the ECB downgrades its growth and inflation forecasts next month, delaying the end of the APP into 2019 is unlikely, as is altering the country weightings within the APP portfolio. More plausible options include pushing out forward guidance on future rate hikes, extending the maturity of the existing bond holdings, or introducing a new TLTRO to support lending. Impact On European Bonds & The Euro: The ECB is most likely to take a less hawkish slant in December, but will not signal any rapid move to begin hiking rates. This outcome will be bearish for the euro, but only neutral at best for overvalued European government bonds. Feature For the European Central Bank (ECB), the countdown is on to the December policy meeting, when a final decision will have to be made on the end of the Asset Purchase Program (APP). The central bank has been signaling throughout 2018 that net new APP bond purchases will stop at the end of the year, with a potential interest rate increase coming in September 2019 at the earliest. That decision on APP, however, will be conditional on the ECB remaining confident in its forecast that inflation will sustainably return to the target of "just below" 2%. Slumping European economic growth in 2018 means that the ECB's forecasts may prove to be too optimistic. This is especially true given the risks to growth and financial stability stemming from Italy's fiscal policy debate with the European Union, softening Chinese demand for European exports, and the uncertainties related to U.S. trade protectionism and the final U.K.-E.U. Brexit deal. Some pundits are even suggesting that the ECB may be forced to extend the APP program beyond December - or look for other ways to prevent a tightening of monetary conditions - even with headline inflation and wage growth having picked up across most countries. Against this increasingly muddled backdrop, what can the ECB credibly announce in December? In this Special Report, jointly published by BCA's Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the state of the euro area economy and then consider the ECB's next potential policy moves, with ramifications for European bond yields and the euro. Our conclusion is that there are a few policy tools available to the ECB in case of a prolonged slump in growth, without having to bring on the operational difficulties from extending the APP beyond December. Such a "dovish" shift would be bearish for the euro but neutral, at best, for European government bonds which remain deeply overvalued. ECB Policy Dilemma: Slowing Growth Vs. Accelerating Inflation At last month's monetary policy meeting, ECB President Mario Draghi noted that the slowing economy was merely returning to trend (or potential) growth from an unsustainably fast pace in 2017 that was fueled by strong export demand. Looking at the broad swath of euro area economic data, Draghi's relatively optimistic assessment is not far off the mark. The euro zone has seen a clear loss of economic growth momentum since the start of the year (Chart 1). The initial read on real GDP for the third quarter, released last week, showed a deceleration to a below-potential quarterly growth pace of 1.7%. The manufacturing purchasing managers index (PMI) has fallen from a peak of 61 in December 2017 to 52 in October, mirroring a -1% decline in the OECD's leading economic indicator for the region. Chart 1A European Growth Slump, Not Yet A Downtrend A European Growth Slump, Not Yet A Downtrend A European Growth Slump, Not Yet A Downtrend Yet not all the economic news has been that weak. Both consumer and business confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with above-trend real GDP growth (bottom two panels). Even though exports have weakened substantially from the booming pace in 2017 - largely due to China's slowing growth - the EC survey on firms' export order books remains at robust levels and overall export growth has rebounded of late (Chart 2). The current conditions component of the euro area ZEW index has also ticked higher (top panel), as has the bank credit impulse (bottom panel). Chart 2Not All The Economic News Is Bad Not All The Economic News Is Bad Not All The Economic News Is Bad The bigger issue for the ECB is that the recent cooling of growth comes at a time when, by almost all measures, there is little economic slack in the euro area. Capacity utilization is running at an 11-year high of 84%, while the output gap is effectively closed according to estimates from the IMF (Chart 3). Chart 3No Spare Capacity In Europe No Spare Capacity In Europe No Spare Capacity In Europe With that gap projected to turn positive in 2019, core inflation in the euro zone should be expected to drift higher. Yet core inflation now remains stuck around 1%, well below the headline inflation figure of 2% that has been heavily influenced by past increases in energy prices (bottom panel). The labor market is sending signals that the current period of low euro area inflation may be turning around. The unemployment rate for the entire region fell to a 10-year low of 8.1% in September, well below both the ECB's latest 2018 forecast and the OECD's estimate of the full employment NAIRU (Chart 4). This tightening labor market is a broad-based phenomenon across the euro area, with nearly 80% of countries in the region having an unemployment rate below NAIRU (middle panel).1 The last two times there was such a broad-based decline in unemployment in the region, in 2001-02 and 2006-07, a significant tightening of monetary policy was required as measured by a simple Taylor Rule. Chart 4Broad-Based Labor Market Strength Broad-Based Labor Market Strength Broad-Based Labor Market Strength Already, the tightening labor market is starting to put upward pressure on labor costs. The annual growth in wages & salaries accelerated to just over 2% in the second quarter of 2018. Similar to the fall in unemployment rates, the faster wage growth has also been widely seen throughout the region, with nearly three-quarters of euro area countries showing faster wage growth from one year ago (bottom panel). The mix of slowing growth momentum with some inflationary pressures can be seen in our ECB Monitor, which measures the cyclical pressures to tighten or ease monetary policy in the euro area. The Monitor had been signaling a need for tighter policy for most of the past two years, but has now fallen back to levels consistent with no change in policy (Chart 5). When breaking down the Monitor into its inflation and growth components, the latter has fallen the most. The inflation components remain in the "tight money required" zone above the zero line. Chart 5Our ECB Monitor Says 'Do Nothing' Our ECB Monitor Says 'Do Nothing' Our ECB Monitor Says 'Do Nothing' Looking across the balance of the euro area data, President Draghi's assessment that the recent economic weakness is not the beginning of a sustained move to below-trend growth is justified. Given the broad evidence pointing to a lack of excess capacity across the euro area economy, it will take a much bigger growth slump before the ECB can shift to a more dovish policy bias. The critical series to monitor will be business confidence, capital spending and export orders. All are at risk of downshifting due to slowing global trade activity and sluggish Chinese demand. BCA's China experts continue to have doubts that the Chinese government will undertake any typical initiatives to stimulate demand, like interest rate cuts or fiscal spending, given worries about high domestic debt levels. Without the impetus from strong Chinese import demand boosting euro area exports, the current tightness of euro area labor markets, and uptrend in wage growth, may be at risk of a reversal, as we discussed in a recent Special Report.2 Bottom Line: Economic growth in the euro area has lost momentum, but it is not clear that an extended period of below-trend growth is unfolding. With most measures of spare capacity showing a lack of it, the ECB must still move forward with its plans to begin removing policy accommodation. What Tools Are Available For The ECB? Net-net, when looking at the broad balance of growth and inflation data at the moment, there is not yet enough evidence to suggest that the ECB needs to back away from its current plans to end net new APP purchases in December. That does not mean that the ECB would not consider changes to its total mix of monetary policy measures. The ECB has treated the APP, which began in 2015, as a "deflation fighting tool" during a period when there was excess capacity and very low inflation in the euro area. That is no longer the case, so it will be difficult for the ECB Governing Council to argue in December that new APP purchases are still necessary. It would take a substantial downward adjustment to the ECB growth and inflation forecasts, with a subsequent upward revision to the expectations for the unemployment rate, for the ECB to reconsider the plans to stop new bond purchases at year-end. Yet the ECB has also made it clear that interest rate hikes will not happen soon after the APP purchases end. Going back over the entire 20-year history of the ECB, there have only been three tightening episodes through rate hikes: 1999-2000, 2003-07 and 2011. In all three cases, what prompted the rate hikes was a period of broad-based increases in euro zone inflation that followed a period of equally broad-based euro zone economic growth. This can be seen in Chart 6, which shows "diffusion indices", or breadth across countries, for euro area real GDP and inflation. A higher number means that a greater percentage of individual nations is experiencing faster growth or inflation, and vice versa. During those three previous tightening cycles, the diffusion indices all reached elevated levels for growth and, more importantly, inflation. With more countries enjoying the upturn, the ECB could be more confident in seeing the need for interest rate increases to cool off demand to prevent an inflation overshoot. Chart 6No Need For ECB Rate Hikes Anytime Soon No Need For ECB Rate Hikes Anytime Soon No Need For ECB Rate Hikes Anytime Soon At the moment, the diffusion indices are quite low, suggesting that few countries are witnessing accelerating growth or inflation. This means that there is no pressure for the ECB to move up its current dovish guidance to the markets about the timing of the first rate hike in late 2019. That also means that there is a risk that the ECB is forced to consider options for providing additional monetary accommodation if there was a large enough downgrade to its growth and inflation forecasts. If the ECB were to indeed lower its growth forecasts in December and consider additional easing options, there are only four plausible options at their disposal: 1) Extending the APP purchases beyond December, either at the current pace of €15bn/month or a slower pace between €5-10bn/month Extending the APP into 2019 is the least likely choice because the ECB is already close to some of the self-imposed constraints on its government bond holdings. The ECB has set a limit of owning no more than 33% of an individual country's allowable government bonds, with maturities of between 1-31 years. Right now, the ECB owns about 31% of all eligible German government debt (Chart 7), and would breach that 33% level sometime in the first half of 2019 if the current pace of buying was maintained without any increase in German bond issuance (i.e. smaller budget surpluses).3 A similar outcome would also occur for smaller bond markets, like the Netherlands and Finland (bottom panel). Chart 7ECB Will Hit Country Issuer Limits If Current APP Is Maintained ECB Will Hit Country Issuer Limits If Current APP Is Maintained ECB Will Hit Country Issuer Limits If Current APP Is Maintained Of course, this is a self-imposed rule by the ECB that can easily be changed. That already occurred back in 2016 when the ECB allowed the purchase of bonds below the deposit rate as part of its APP operations. This meant that the ECB would buy bonds with negative yields, essentially guaranteeing a loss assuming that the bonds were held to maturity. Yet given how much emphasis the ECB has placed on abiding by the issuer limits, we think the ECB would consider other policy choices before raising them. 2) Changing the composition of the APP portfolio Changing the mix of bonds within the APP portfolio is a more likely option, but even this has its limits. The ECB could choose to buy more corporate bonds or covered bonds, but those are less liquid markets where there is arguably more evidence that ECB buying has impacted market functionality. The ECB may be reluctant to take on more credit risk in its bond portfolio, as well. At the country level, the ECB could choose to move away from using its Capital Key weightings to determine the allocation of its bond purchases by country. In the current heated political atmosphere in Europe, however, with the populist Italian government in a very public battle with the E.U. over its 2019 budget, the ECB will not want to be seen as favoring any country more than another by buying more government bonds in places like Italy or Spain over Germany and France. That can already be seen in how bond purchases have been allocated in 2018, with purchases sticking closer to the Capital Key weightings in Italy and France from the larger weightings seen in 2017 (Charts 8 & 9). Chart 8The ECB Capital Key ... The ECB Capital Key... The ECB Capital Key... Chart 9... Is Not Always Adhered To ...Is Not Always Adhered Too ...Is Not Always Adhered Too A more likely reallocation of bond holdings could occur within each country by adjusting the maturities held within the ECB's portfolio. Following the template of the Fed's 2012 "Operation Twist", the ECB could aim to sell shorter-dated bonds in exchange for longer-maturity debt, thereby exacting a flattening influence on government yield curves. There is scope for that in Germany, where the weighted-average-maturity (WAM) of the ECB's bond holdings has decline by 18 months since peaking in late 2015 (Chart 10). Large declines in WAW have also occurred for Spanish, Italian and Portuguese bonds owned by the ECB, if policymakers were willing to take on more duration risk in the Periphery. Chart 10The ECB Has Room To Extend Its APP Maturities The ECB Has Room To Extend Its APP Maturities The ECB Has Room To Extend Its APP Maturities 3) Extend forward guidance on the first rate hike The easiest option for the ECB in the event of a downgrade of its growth/inflation projections is to simply extend the forward guidance on the timing of the first interest rate hike. Right now, our Months-to-Hike indicators, which measure the time until a full rate hike is discounted in the European Overnight Index Swap (OIS) curve, are discounting a hike of 10bps by November 2019 and a hike of 25bps by May 2020 (Chart 11). The ECB could easily signal that any rate hike, of any size, would not occur before the latter half of 2020 if an additional easing move was required. This would mostly likely result in lower bond yields and a weaker euro, all else equal, helping easy monetary conditions in the euro area. Chart 11Extending Forward Guidance Is An Option Extending Forward Guidance Is An Option Extending Forward Guidance Is An Option 4) Introduce a new Targeted Long-Term Lending Operation (TLTRO) One final intriguing option for an ECB policy ease would be the introduction of another TLTRO. The last such targeted lending program occurred in 2016, but the first wave of the much larger program that began in 2014 has already started to run off the ECB's balance sheet. This is the most effective way to get European banks to extend credit to borrowers at lower interest rates, since the banks would be able to fund that borrowing via the TLTRO at a rate lower than market rates. President Draghi did note last month that some members of the Governing Council brought up the idea of a new TLTRO at the ECB's policy meeting, and some well-known investment banks have recently discussed the implications of a new operation. In our view, a new TLTRO is the most effective way for the ECB to provide stimulus via lower private borrowing rates. It would also help offset any negative ramifications of the reduction of the ECB's balance sheet from the expiration of prior TLTROs. This would likely only happen, though, if there was evidence that the credit channel was impaired in the euro area. The previous TLTROs occurred after a period when banks were tightening credit standards, corporate borrowing rates and credit spreads were widening, European bank stocks were falling and European bank lending standards were becoming more restrictive (Chart 12). Chart 12A New TLTRO? Watch Lending Standards A New TLTRO? Watch Lending Standards A New TLTRO? Watch Lending Standards Today, bank stocks are falling and corporate bond yields/spreads are low but slowly rising, while European banks are actually easing lending standards according to the ECB's Q3 Bank Lending Survey. If the latter were to flip into the "tightening standards" zone, without any rebound in European bank shares or decline in corporate borrowing rates, the ECB could be tempted to go down the TLTRO route once again. Bottom Line: If the ECB downgrades its growth and inflation forecasts next month, delaying the end of the APP into 2019 is unlikely, as is altering the country weightings within the APP portfolio. More plausible options include pushing out forward guidance on future rate hikes, extending the maturity of the existing bond holdings, or introducing a new TLTRO to support lending. Likely ECB Options & Investment Implications In our view, the most realistic outcomes for the December ECB meeting can be boiled down to two decisions, conditional on how the ECB's economic forecasts are presented: 1) Unchanged growth & inflation forecasts: The ECB will signal the end of new APP bond purchases at the end of December, while maintaining the current forward guidance on rate hikes that no move will occur until at least September 2019. 2) Downgraded growth & inflation forecasts: The ECB will signal the end of new APP bond purchases at the end of December, but will also push out forward guidance on the first rate hike to at least sometime in mid-2020. In the latter scenario, the ECB could also consider two other options: extending maturities within its German bond holdings, or announcing a new TLTRO. We think that the ECB will wait to see how financial markets absorb the end of new APP buying before considering any move on maturity extension. At the same time, the ECB would signal that a TLTRO is a possibility if lending standards deteriorate and borrowing rates climb higher. While the ECB has talked a lot about how they will continue to reinvest the proceeds of maturing bonds in its portfolio, similar to what the Federal Reserve did after it ended its QE buying, the bigger impact on bond yields will come from a worsening of the supply/demand balance for European bonds. The ECB has been buying amounts greater than the entire net bond issuance of all euro area governments since the APP started in 2015, which has created a scarcity of risk-free sovereign debt for private investors. The result: extremely low bond yields, with a negative term premium (Chart 13). Reduced ECB buying will result in more bonds that have to be purchased by private investors, and a less negative term premium, going forward. Chart 13Bund Term Premium Unwind? Bund Term Premium Unwind? Bund Term Premium Unwind? How high euro area bond yields eventually go will then be determined by more traditional factors, like inflation expectations and the expected path of ECB rate hikes. Going back to the ECB's previous tightening cycles over its existence, actual rate hikes did now occur before inflation expectations - as measured by 5-year CPI swaps, 5-years forward - rose above 2% (Chart 14). Those inflation expectations are now 32bps below that level, and the ECB will not begin to shift to less dovish forward guidance unless the markets begin to discount more stable inflation close to the ECB's "near 2%" target. Chart 14Not Enough Inflation (Yet) To Justify Rate Hikes Not Enough Inflation (Yet) To Justify Rate Hikes Not Enough Inflation (Yet) To Justify Rate Hikes Dovish guidance on future ECB rate hikes will continue to widen the U.S.-Europe interest rate differentials that have helped weaken the euro versus the U.S. dollar in 2018 (Chart 15). This will continue to put downward pressure on EUR/USD cross, particularly with neutral momentum and positioning indicators suggesting that the euro is not yet oversold (bottom panel). Chart 15Likely ECB Actions Are Euro-Bearish Likely ECB Actions Are Euro-Bearish Likely ECB Actions Are Euro-Bearish Bottom Line: The ECB is most likely to take a less hawkish slant in December, but will not signal any rapid move to begin hiking rates. This outcome will be bearish for the euro, but only neutral at best for overvalued European government bonds. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Since not every country in the euro area is also part of the OECD, we could only use 14 of the 19 countries in the euro area in the indicator shown in the middle panel of Chart 5. 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?, dated October 6th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. 3 The ECB does allow the purchase of both federal government bonds, as well as the debt of government agencies and supranationals, as part of its APP. For our projections, we have assumed that of the €15bn in net new bonds that the ECB buys each month, 82% are debt issued by government-related entities (i.e. 18% goes to credit instruments like corporate bonds and covered bonds), with 10% of those government purchases going to supras. From that reduced number, we assume anywhere from 10-30% of purchases go to agencies, depending on the country. For the sake of simplicity, we also assume a pace of net government bond issuance in line with that seen over the past year, rather than make specific assumptions on changes in individual country budget deficits.