Economy

Highlights U.S. domestic demand will remain robust for the foreseeable future thanks to fiscal stimulus, stronger credit growth, a falling savings rate, and plentiful sources of pent-up demand. Economic and financial imbalances in the U.S. are also muted, while the financial system is fairly resilient. All this implies that the Fed can raise rates quite a bit more - certainly above the 3% level that the market regards as the threshold at which the economy will go off the rails. Since both monetary and fiscal policy will remain accommodative for the foreseeable future, a recession is unlikely before 2020, with risks tilted to an even later onset date. The combination of a stronger dollar, slowing global trade, high EM debt levels, and the Chinese government's reluctance to pursue a massive fiscal/credit stimulus program due to concerns about financial stability and debt sustainability, all spell trouble for emerging markets. Investors should favor developed market equities over their EM counterparts. Within the developed market universe, remain overweight the U.S. over both Europe and Japan in common-currency terms. As we predicted two years ago, bonds have entered a secular bear market. However, a temporary countertrend rally is a growing risk in the near term, especially in light of extremely stretched short positioning and technically oversold conditions. Feature A New Record Will Be Set Next Year The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion (Chart 1). Will it last that long? We think so. In fact, the risk to our 2020 recession call is tilted towards a later downturn rather than an earlier one. Chart 1The Current Economic Expansion Will Likely Be The Longest On Record To understand why, it is useful to consider the forces that generate recessions. In one sense, business cycles are very simple things: Recessions occur when spending begins to decline in relation to the economy's productive capacity. This often sets in motion a vicious circle where rising unemployment reduces both income and confidence, leading to less spending and even higher unemployment. Conversely, recoveries occur when spending rises relative to the economy's productive capacity. This may happen because fiscal and/or monetary policy turn stimulative. It can also happen because the excesses that were built up in the lead-up to the recession are purged, allowing the economy to grow from a clean slate. Lessons From The Great Recession The Great Recession offers a vivid demonstration of these processes. The run-up in home prices starting in the early 2000s pushed up consumption. Rising housing demand also lifted residential investment. Once the housing bubble burst, everything went into reverse: Home prices and construction collapsed. Household debt, which had grown rapidly over the preceding 25 years, began to contract. The importance of shifts in aggregate demand in explaining business-cycle fluctuations may seem simple if not obvious, but it is remarkable how many people fail to understand them. One of the more strangely controversial reports I wrote while working in the global markets group at Goldman Sachs in September 2009 was a piece predicting that the Fed would need to keep rates low for "many years" to come.1 It is easy to forget now, but the U.S. 10-year yield rose as high as 3.92% in December 2009 on the expectation that the Fed would start "normalizing" monetary policy in the near future (Chart 2). Chart 2Rate Expectations Were Too Hawkish Shortly After The Great Recession, But Are Now Too Dovish Those who understood the mechanics of recessions and recoveries should have realized that the Fed would not be able to abandon its ultra-loose monetary stance so quickly. Yes, the financial crisis had ended in the sense that credit spreads were falling, equity prices were recovering, and fears of a massive bank run were receding. But the sources of demand that propped up spending prior to the Great Recession were not coming back anytime soon. The U.S. needs about 3.5% of GDP in residential investment to keep up with population growth. After the recession ended, it probably required something closer to 2% of GDP in residential investment in order to work off the excess inventory of homes that was created during the bubble years. Residential investment averaged nearly 6% of GDP between 2002 and 2006. Where exactly was that 4% of GDP in lost demand going to come from? Certainly not from the Obama stimulus package, which was too small and too transient. Likewise, while one could have reasonably debated in 2009 the extent to which debt levels would ultimately fall, it should have been pretty obvious that they would not start rising at least for the next few years. Conceptually, the level of demand is determined by the rate of growth of debt.2 Rising debt added to aggregate demand in the years leading to the Great Recession. If debt levels had simply stabilized in the aftermath of the recession, this would have still left the economy with less spending power than it had before the downturn. It took a long time, but by 2016 investors had finally internalized the lessons discussed above. The U.S. 10-year yield hit a record closing low of 1.37% on July 5, 2016. As luck would have it, this was also the day that we published a note declaring "The End Of The 35-Year Bond Bull Market." Our decision to turn more cautious on bonds was motivated by both valuation considerations and the fact that many of the forces that had dragged down bond yields were starting to drive them back up: The output gap had shrunk; fiscal policy had become more stimulative; and credit was growing anew. In addition, eight years of frugal living created plenty of pent-up demand for fixed capital and consumer durable goods. Chart 3 shows that the average age of the residential capital stock shot up from 25.8 years in 2007 to 30.1 years in 2016. The average age of the nonresidential capital stock also continued to drift up, rising to the highest level since 1963. The average age of consumer goods also increased (Chart 4). Chart 3The U.S. Capital Stock Has Aged (Part I) Chart 4The U.S. Capital Stock Has Aged (Part II) Where Things Stand Today This brings us to the present. Today, the output gap is fully closed, private-sector credit growth has returned to its long-term trend, and fiscal policy is even looser than it was two years ago (Chart 5). The replacement cycle for business investment still has further to run. Both capex intention surveys and the recent easing in lending standards for commercial and industrial loans suggest that capital expenditures will remain strong for the foreseeable future (Chart 6). Meanwhile, household spending will be supported by accelerating wage growth and a savings rate that has plenty of scope to fall from current levels (Chart 7). Chart 5The Need For Ultra-Low Rates Has Passed Chart 6Business Investment Still Going Strong Chart 7Stronger Wage Growth And A Falling Savings Rate Will Lift Spending Perhaps most importantly, the sort of financial imbalances that have triggered recessions in the past are largely absent today. Unlike a decade ago, the mortgage market is in good shape. The Urban Institute's Housing Credit Availability Index, which measures the percentage of housing loans that are likely to default over the next 90 days, remains near all-time lows (Chart 8). The corporate debt market is more problematic, and we continue to see it as the "weakest link" in the financial system. The ratio of corporate debt-to-GDP has climbed to a record high, while so-called "covenant-light loans" have proliferated. The situation is particularly bad among companies with publicly-traded bonds, who have generally been the worst offenders. Nevertheless, the situation is far from dire. The ratio of corporate net debt-to-EBITD is still reasonably low. The interest coverage ratio is fairly elevated, as is the "quick ratio," which takes the difference between current corporate assets and inventories and divides it by short-term liabilities. Corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 9). Chart 8U.S. Mortgage Market Is In Good Shape Chart 9Corporate Debt: Problematic, But Far From Dire Looking out, rising interest rates will lift debt-servicing costs while faster wage growth will put downward pressure on profit margins. This is likely to strain corporate balance sheets, causing spreads to widen from today's ultra-low levels. However, a major wave of defaults is unlikely to occur unless earnings collapse, which rarely happens outside of recessions. The Financial System Is More Resilient Is it possible that rising defaults will force firms to lay off workers, leading to less spending throughout the economy, higher corporate defaults, and even more layoffs? Such a vicious circle cannot be dismissed, but its likelihood is mitigated by the fact that most corporate debt is held by unleveraged investors. Defaults are most economically pernicious when they lead to "leveraged losses," a term coined by my former Goldman Sachs colleague, Jan Hatzius. If a leveraged institution wishes to hold ten times as much assets as capital, a $1 loss on a bad loan will force it to reduce its assets by $10. This could result in a downward spiral in asset prices - one where fire sales lead to big haircuts to asset holders, generating even more forced sales. A credit crunch is almost inevitable in such a scenario. Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 10). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 11). Chart 10Banks Have Reduced Their Exposure To The Corporate Sector Chart 11U.S. Banks Are Well Capitalized Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 12). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 12Corporate Debt Scare: 2015 Was A Preview No Recession On The Horizon The discussion above suggests that U.S. aggregate demand growth will remain robust for the foreseeable future thanks to fiscal stimulus, stronger credit growth, a falling savings rate, and still-abundant sources of pent-up demand. Economic and financial imbalances are also muted, while the financial system is fairly resilient. All this implies that the Fed can raise rates quite a bit more - certainly above the 3% level that the market regards as the threshold at which the economy will go off the rails (Chart 13). Comments this week from key Fed officials, including Chair Powell, suggest that the FOMC is finally starting to see things our way. Since it will take a while for the Fed to lift interest rates into restrictive territory, it follows that the next recession is nowhere on the horizon. This observation is supported by a variety of leading economic indicators, including the ISM index, initial unemployment claims, and core durable goods orders (Chart 14). Only the yield curve is sending a modestly worrying signal, although as we discussed in a prior report,3 the danger posed from a flatter yield curve is lower today than in the past. Chart 13Markets Expect No Fed Hikes Beyond Next Year Chart 14No Imminent Risk Of A U.S. Recession It will not be until 2020, and perhaps even later, that monetary policy turns restrictive. By that time, imbalances will have grown, which implies that debt levels and asset prices will probably be higher. The unemployment rate could be in the low 3% range and core PCE inflation will likely have moved squarely above the Fed's target. Risks To The View While our baseline scenario foresees a recession happening later rather than sooner, it would be unwise to ignore the risks to that sanguine view. Four things could hasten an economic downturn: A full-blown trade war with China: Trump's procyclical fiscal policy will drain domestic savings, causing the current account deficit to widen. Since Trump is unlikely to blame his own macro policies for a rising trade deficit, he will try to find a scapegoat. He cannot blame Canada or Mexico anymore since he just negotiated a "tremendous" new USMCA agreement with them, which allegedly redresses all the injustices of the prior trade deal. Japan and the EU will also get a break, if for no other reason than they are still needed as geopolitical allies. This just leaves China as the fall guy. The risk is that the Chinese government not only raises tariffs on U.S. exports, but also retaliates against U.S. firms with operations in China. Even more dangerously, a trade war with China could escalate into an outright military conflict. The underreported story of the near collision between a Chinese warship and a U.S. destroyer this week highlights the risk of such an outcome.4 An oil superspike: Our energy strategists have argued that extremely tight supply conditions, exacerbated by sanctions against Iranian oil exports, could cause the price of crude to shoot up to $100 dollars per barrel by early next year. Every U.S. recession over the past 40 years has been preceded by a rapid increase in oil prices (Chart 15). While there are reasons to think that an oil shock would be less damaging than in the past - the U.S. is now a net energy exporter; the volume of oil consumption as a share of real GDP has fallen by a third since 1995, and by half since 1980; inflation expectations are much better anchored - a big enough oil spike, if combined with other adverse shocks, could create the conditions for another recession. An Italian sovereign debt crisis: Italy is caught between a rock and a hard place. The Italian private sector saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 16). Unlike Germany, Italy cannot export its savings to the rest of the world through a large trade surplus because it does not have a hypercompetitive economy. Nor can the Italian government risk running afoul of the bond vigilantes by emulating Japan's strategy of absorbing private-sector savings with large budget deficits. It is unlikely that these tensions will come to a head before the next global recession. Nevertheless, Italy's fiscal woes certainly make global financial markets more vulnerable to a risk-off event. Emerging market meltdown: As our EM strategists have highlighted, the combination of a stronger dollar, slowing global trade, high EM debt levels, and the Chinese government's reluctance to pursue a massive fiscal/credit stimulus program due to concerns about financial stability, all spell trouble for emerging markets. It is doubtful that an EM crisis would bring down the U.S. economy - even the 1990s crises did not do that - but it could exacerbate a preexisting slowdown, especially if the spillovers from EM lead to a tightening in U.S. financial conditions via a sharp appreciation of the dollar, wider credit spreads, and a selloff in U.S. stocks. Chart 15Rapid Increases In Oil Prices Tend To Precede Recessions Chart 16Italy: Private Sector Saves Too Much And Spends Too Little Investment Conclusions In many respects, the economic and financial landscape today resembles that of late-1997 and early-1998. Back then, the U.S. stock market was rallying while emerging market assets were selling off. The decoupling between U.S. and global stocks came to a thunderous end in the summer of 1998. Popular lore attributes the 22% plunge in the S&P 500 from July 20 to October 8 to the implosion of Long-Term Capital Management (LTCM), but in fact almost all of the decline in the index occurred before the problems at LTCM surfaced. It was more the steady drip of bad news over the course of 1998 - the spread of the crisis from Thailand to Indonesia, Malaysia, and South Korea; the collapse of Hong Kong-based Peregrine Investments Holdings, Asia's largest private investment bank; growing fears that China would devalue its currency; and finally, the Russian sovereign debt default - which caused market sentiment among U.S. investors to turn from euphoric ambivalence to bearish hysteria (Chart 17). Chart 17Key Events During The Asian Crisis It is impossible to know if such a phase-transition will occur again, but prudent investors should consider scaling back risk if they are currently overweight risk assets. We moved to neutral from overweight on global equities in June, while maintaining our preference for developed over emerging markets. Within the developed market universe, we continue to favor the U.S. over both Europe and Japan in common-currency terms, given our expectation of further dollar strength. If global stocks do suffer a correction during the next few months, this will present a buying opportunity. U.S. equities, which account for over half of global stock market capitalization, tend not to peak until six months or so before the start of a recession (Table 1). Keep in mind that the S&P 500 rallied by 68% between its October 1998 lows and April 2000. Emerging market stocks bottomed in September 1998, before doubling over the subsequent 18 months. Following this script, we expect to flip our recommendation from being underweight to overweight EM equities at some point in 2019, probably in the first half of the year. The 1998 template is also helpful for thinking about the outlook for bond yields. The 10-year Treasury yield rose from 4.16% in October 1998 to 6.79% in January 2000, but not before falling from nearly 7% in April 1997. We do not expect a similar decline in yields this time around, but a modest dip from current levels would not be surprising, particularly because bond sentiment is highly bearish at the moment (Chart 18). As with stocks, any decline in bond yields would be temporary. Bonds are now in a secular bear market that could last a decade, if not longer. Our baseline views for global equities, bonds, currencies, and commodities are illustrated in Appendix A. Table 1Stocks And Recessions: Case-By-Case Chart 18Bond Sentiment Is Very Bearish Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 "Goldman Says Deleveraging May Keep Fed Rate Low for 'Years,' " Bloomberg, September 10, 2009. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Please see Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 4 Steven Lee Myers, "American and Chinese Warships Narrowly Avoid High-Seas Collision," The New York Times, October 2, 2018. Appendix A Appendix Chart IMarket Outlook: Equities Appendix Chart IIMarket Outlook: Bonds Appendix Chart IIIMarket Outlook: Currencies Appendix Chart IVMarket Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights European and Japanese wages have firmed significantly, suggesting upside to inflation in these economies. However, the gain in European wages will soon reverse, as the slowdown in global trade percolates through the European economy. The ECB will not raise rates sooner or faster than currently discounted in markets, and German Bunds remain attractive in currency hedged terms. Japanese wage growth seems more sustainable but Japanese inflation expectations remain anchored to the downside, and Japan will suffer from a fiscal shock when the consumption tax is increased next October. Japan's YCC policy will remain in place for at least another 18 months, and fixed-income investors should continue to overweight JGBs in currency-hedged fixed income portfolios. Feature The pick-up in wage growth this summer in the euro area and Japan has been an interesting development. It raises the risk that inflation in these two economies is about to hit an inflection point. Since growth has returned to these two regions, if inflation were to join the party, the European Central Bank and the Bank of Japan would finally be able to follow in the Federal Reserve's footsteps and begin increasing rates sooner rather than later. This week we explore whether or not inflationary pressures are building in Europe and Japan, and whether or not the expected policy path of the ECB and the BoJ needs to be re-assessed. While cyclical pressures are growing, clouds above the global economy - the EM space in particular - suggest that the policy path currently anticipated by money markets is just right, and no glaring mis-pricings are evident. Euro Area: A Dawn Is Not A Sunrise The Necessary Condition For Inflation Is Here... There is no denying that we have seen massive improvements in the euro area economy. In fact, we would argue that the euro area has finally hit a stage where the necessary condition for a re-emergence of inflation has been met: Economic slack has vanished. There seems to be little spare capacity in the aggregate euro area economy. Today the OECD measure for the output gap stands at +0.5% of GDP. Additionally, a basic approach comparing the level of industrial production to a simple statistical filter further confirms this assessment, showing that production stands 2% above trend (Chart 1). The capacity utilization measure published by the European Commission goes one step further, showing that utilization is at its highest level since 2008. This represents a very significant change from the days of 2011-2015, when capacity utilization stood below the average that prevailed from the time of the euro's introduction (Chart 2). Chart 1No More Slack In Europe Chart 2Capacity Utilization Is At Previous Cycle Peaks The labor market has been a particular source of concern for euro area watchers. After all, how can an economy generate any domestic inflationary pressures if wages remain depressed? On that front too, there is plenty to rejoice about. The gap between the euro area's unemployment rate and the OECD's estimate of the non-accelerating rate of unemployment (NAIRU) has nearly fully disappeared. Historically, such an occurrence has been associated with a rise in European core inflation (Chart 3). In fact, the ECB's labor underutilization survey is now at its lowest level in 10 years. Moreover, in its various business conditions surveys, the European Commission asks firms whether labor is a factor limiting production. With the exception of Italy, the number of firms reporting that labor shortages are a problem in most of the major economies stands at or near record highs (Chart 4). This confirms the simple impression provided by the gap between the unemployment rate and NAIRU that the labor market is beginning to create generalized inflationary and wage pressures. Chart 3Diminishing Labor Market Slack Leads##br## To Growing Inflationary Pressures Chart 4Labor Shortages In ##br##The Euro Area ...But The Sufficient Conditions Remain Murkier While the tight labor market suggests that wages have cyclical upside, is it even true that higher wages do lead to higher inflation in the euro area? The answer is yes. Chart 5 shows that euro area wages tend to lead core CPI by approximately three quarters, with an explanatory power of nearly 87%. This makes sense. Higher wages increase the cost of production for businesses, which results in cost-push inflation. This is even more true if wages rise in real terms, which boosts household's income and supports consumption. Thus, it is likely that the recent spike in wages will lead to higher core inflation. Despite this positive backdrop, some key cyclical worries remain. First, our CPI diffusion index for the euro area, measuring the breadth of inflation increases within the subcomponents of the CPI, is in free-fall. Historically, this has been a worrying sign for core inflation, and for both nominal and real wages (Chart 6). Chart 5In Europe, Wages ##br##Lead Core CPI Chart 6But CPI Diffusion Index Suggests Real Wages ##br##And Core CPI Could Hit A Speed Bump The bigger risk originates from outside the euro area. We have shown in the past that EM shocks can have a disproportionate impact on European economic activity.1 This link seems to run deeper than we had originally realized. As Chart 7 shows, euro area nominal and real wages tend to follow the trend in European exports to EM and China. The logical conclusion is that export shocks end up affecting the whole economy by depressing profits, capex and the willingness of firms to provide wage increases to their employees. This also ends up reverberating into consumption as both nominal and, more importantly, real wages suffer. Today, weakening exports to EM and China suggest that European wages may soon roll over. This would take the wind out of price inflation as well, since wages lead core CPI by roughly three quarters. BCA's Foreign Exchange Strategy service as well as our Emerging Market Strategy sister publication have already highlighted that EM economies are likely to slow further in the coming quarters as China works to de-lever - a process which has already begun (Chart 8).2 Thus, the negative impact of EM on European growth and wages is likely only to grow over the coming quarters. The euro area leading economic indicator (LEI) has already picked up on these dynamics. The deterioration in the LEI suggests that real wages are likely to soon suffer, which will further dent euro area consumption and weigh on core inflation (Chart 9). Chart 7Exports To EM Are The Culprit##br## Behind This Speed Bump Chart 8Limited Upside Ahead##br## In Chinese Growth Chart 9Euro Area LEI Confirms##br## The Message From Exports Adding up those various message we conclude that while we could soon see some upside in inflation via a pass-through of the recent pick-up in wages, the upside is likely to prove transitory as the euro area economy will soon feel the deflationary impact of the slowdown in EM economic activity. What Will The ECB Do? The ECB will end its asset purchase program at the end of this year. Money markets are currently pricing in a full 25-basis-point hike in interest rates by March 2020. However, various formulations of the Taylor Rule suggest that euro area interest rates should already be higher than they currently are (Chart 10). What are interest rates likely to really do in relation to this date? Despite these hawkish Taylor Rule estimates, we think the ECB is likely to wait and see. As we highlighted above, the slack in the euro area economy is dissipating, and therefore inflationary pressures are bound to build up. However, the slowdown in EM that is reverberating through global trade will weigh on inflation over the coming six months. Additionally, we need to monitor developments in shadow policy rates.3 After the Fed began tapering its asset purchases in 2014, the U.S. shadow rate increased by roughly 300 basis points. While the actual fed funds rate was not raised until the end of 2015, the implied tightening from the rise in the shadow rate was enough to cause both U.S. and non-U.S. growth to slow sharply in 2015. Since bottoming in November 2016, the ECB's shadow rate has increased by 450 basis points. Even if European monetary conditions remain accommodative, this is a large and sudden shock to absorb - one that goes a long way in explaining the sudden contraction in the euro area credit impulse (Chart 11). Chart 10Does Europe Really Need Higher Rates? Chart 11Large Tightening In Euro Area Shadow Rate Ultimately, while the reduction in the euro area economic slack is real, the aforementioned dynamics are worrisome. Hence, we do not think that the ECB will want to prematurely kill off the recovery. Memories of the policy mistake of 2010, when the ECB raised rates in a too-weak economy, are still very much alive on the ECB's Governing Council. This means that a small first hike of less than 25 basis points in late 2019 or early 2020 seems appropriate, as there should be more convincing evidence by then that the economy can tolerate higher interest rates. Hence, there does not seem to currently be any mis-pricing in the European interest rate curve since investors are correctly pricing in a full 25-basis points of hikes from the ECB by March 2020. Investment Implications We continue to recommend U.S. investors hold European bonds while hedging the currency exposure back into U.S. dollar. A hedged 10-year Bund currently yields 3.66%, compared to 3.2% for a 10-year Treasury note. The picture above does not suggest that Bund yields will have enough upside to generate the capital losses needed to offset this yield pick-up, especially as Treasury prices suffer greater potential downside. This also means that once hedging costs are taken into account, European fixed-income investors are better off staying at home than playing in the U.S. government bond market. The impact for EUR/USD is more complex. The U.S. Overnight Index Swap (OIS) curve is currently pricing in roughly three rate hikes by the Fed over the next 12 months. BCA think that there could be even more U.S. rate hikes as the Fed continues to follow a 25 basis-points-per-quarter pace. Thus, we do not see the spread between U.S. and euro area interest rates narrowing in a more bullish direction for the euro Moreover, currencies trade on more than just interest rate differentials. The dollar has historically responded favorably to slowing EM growth. Moreover, as we highlighted three weeks ago, since the U.S. balance of payments is currently in surplus, this means that the U.S. is sucking in liquidity from the rest of the world.4 This is another way of saying that the world is buying more dollars than the U.S. is supplying. As a result, the dollar could continue to experience upside versus the euro over this period from factors beyond simple rate differentials. Bottom Line: The euro area economic slack has greatly dissipated and the medium term outlook for inflation is improving. Moreover, the recent pick-up in euro area wages suggest that core CPI could also pick up in the coming months. However, this increase in inflation is likely to prove temporary. Before inflation can increase durably, Europe will first have to digest the deflationary impact of slowing EM economies and global trade. This means that the ECB is likely to proceed with policy normalization very cautiously. The current pricing of 25 basis points of hikes by March 2020 is sensible. Hence, investors should continue to overweight Bunds hedged back into dollars in global fixed income portfolios. Moreover, EUR/USD could experience additional weaknesses on a 12-month basis. Japan: Fragile Progress, But Not Enough This past June, Japanese wage growth hit rates not seen in 21 years. This is enough to begin wondering if Japan is finally escaping its two-decades-long deflationary trap. After all, as Chart 12 shows, Japanese wages are a slow but nonetheless leading indicator of core inflation. Giving even more comfort to forecasts of higher Japanese inflation is the fact that, after falling continuously from the bubble peak in the early 1990s until Q1 2017, Japanese land prices have been slowly but surely increasing. Inflationary pressures in Japan are building up because the economy is at full employment. According to the BoJ, the output gap stands at +1.9% and has been positive for two years. The unemployment rate is at a stunningly low level of 2.4%, and the active job opening-to-applicant ratio stands at a four-decade high. The implications of this backdrop are evident. Chart 13 shows the demand/supply condition component of the Tankan survey of Japanese businesses, both in the manufacturing and non-manufacturing sectors. It has historically been a good explanatory variable for wage developments in Japan, and currently points to additional strength. Chart 12Rising Japanese Wages Should Boost Core Inflation Chart 13Capacity Pressures Are Lifting Japanese Wages Despite these positive developments, there remain some nagging worries. For one, the pick-up in wages seems strange in an economy where total hours worked are not rising (Chart 14). Moreover, Japanese households are currently increasing their savings ratio, which means that while they might be earning more, they are keeping this money in their bank accounts rather than spending it (Chart 14, bottom panel). As a result, there has been a limited pass-through of the recent wage acceleration into higher consumption. Additionally, like in Europe, the Japanese economy is at risk from foreign shocks. While the domestic economy seems robust, foreign machinery orders have been weakening. Industrial production has followed this path, decelerating sharply (Chart 15). Historically, Japanese inflation is very sensitive to the level of broader economic activity, so this weakening trend in industrial activity points to limited upside for overall inflation. Chart 14Weird Dynamics In Japan Chart 15Japan: The Domestic Front Is Healthy, The Foreign One Is Not The biggest problem faced by the BoJ, however, remains the weakness in inflation expectations. In the eyes of the Japanese central bank, the reason why Japanese realized inflation and wage growth have remained tepid is because decades of low inflation have created embedded expectations among the Japanese to not expect rising prices. Today, Japanese inflation expectations are once again weakening, a common occurrence when global growth slows (Chart 16). Additionally, Japan could hit a fiscal cliff of sorts next year. In October 2019, the consumption tax will increase from 8% to 10%. The last such increase - a three-percentage point hike in 2014 - caused a major slowdown in economic activity that had a deep deflationary impact. While the increase this time around is smaller and the Japanese economy is stronger than in 2014-2015, it remains to be seen how the country handles the shock of a fiscal tightening via a higher sales tax, especially if exports to EM remain on their downward path. The BoJ is likely to be very cognizant of this risk. Currently, the low level of inflation means that the real BoJ policy rate is in line with that of the U.S., a much stronger economy (Chart 17, top panel). Since Japan still faces a fiscal cliff next year and inflation expectations have not yet been unmoored to the upside, the current increase in wages is not enough to push the BoJ to abandon its Yield Curve Control (YCC) policy. What about QQE? The low shadow rate means that the BoJ does not need to buy assets anymore (Chart 17, bottom panel). Yet, the problem for Japan is that QQE possesses a strong signaling component. Ending this program is likely to cause markets to price in the end of YCC, which would drive nominal rates higher and thus result in both higher real rates and a significant tightening in monetary policy. As a result, we expect QQE to remain in place so that YCC will stay credible. However, the program is likely to have a slower pace of buying than before and will be too small to fully absorb the new issuances of JGBs by the MoF (Chart 18). Chart 16The BoJ's ##br##Number 1 Problem Chart 17The Signaling Effect Of QQE Is##br## Still Needed Because Of YCC... Chart 18...But QQE Doesn't Need To Be ##br##Quite As Large Anymore In terms of signposts that would signal to us to begin betting on an end to YCC, we continue to target three things that must ALL happen in unison, highlighted by BCA's Chief Global Fixed Income Strategist, Rob Robis, in February:5 USD/JPY rises at least to the 115-120 range; Japanese core CPI and nominal wage inflation both rise above 1.5%; 10-year JGB yields reaching an overvalued extreme, based on a model that includes potential GDP, BoJ purchases and the level of 10-year Treasury yields. So far, none of these conditions has been met. In fact, the slowdown in global trade and EM activity could even threaten the current improvement witnessed in wages. As a result, we expect all three of these developments to only happen in 2020, leaving Japanese yields with very limited upside. Investment Implications Japanese fixed-income investors continue to be subsidized to remain at home and avoid U.S. Treasuries. Because short rates in Japan are so low, the yield on 10-year U.S. Treasuries hedged into yen yield is 0.05%, less than the 0.16% yield on 10-year JGBs. At the same time, U.S. fixed income investors are incentivized to buy JGBs and hedge the currency exposure into dollars. Additionally, with the BoJ unlikely to abandon its YCC program for potentially two more years, JGBs with up to 10-year maturities are unlikely to suffer capital losses. Largely for this reason, BCA's Global Fixed Income Strategy's recommended model bond portfolio, maintains a large overweight position in JGBs, but only for maturities less than 10 years as the BoJ's YCC program is not focused on yields beyond the 10-year point. Regarding the yen, the outlooks is treacherous. On one hand, a strong USD implies a weaker yen. So do higher 10-year Treasury yields, especially if JGB yields possess little upside. On the other hand, weakness in the EM space tends to result in a stronger yen as carry trades get unwound. Due to these bifurcated risks, we do not recommend buying the yen against the dollar. However, we think that at current levels the yen remains an attractive play against the euro and against the Australian dollar, especially on a six- to nine-month basis. Bottom Line: Japanese wages have enjoyed significant upside, but Japanese inflation expectations remain moribund. Moreover, Japan is likely to experience a negative fiscal shock next year as the consumption tax will once again be increased. These two risks, in addition with slowing global growth, mean that the BoJ is unlikely to abandon YCC until well into 2020. As a result, investors should continue to overweight JGBs with maturities of less than 10-years hedged back into U.S. dollars in a global fixed income portfolio. USD/JPY should enjoy further upside on a 12-month basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "ECB: All About China", dated April 7, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com and Emerging Markets Strategy Special Report, titled "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 3 The shadow rate is a measure of the impact of the various unorthodox policy initiatives implemented by central banks in the wake of the great financial crisis. It tries to express the effect of those measures in terms of the implied levels of policy rates that would have needed to prevail for the economy to generate the same performance if asset purchases had not been implemented. 4 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergences Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 5 Please see Global Fixed Income Strategy Special Report, titled "What Would It Take For The Bank Of Japan To Raise Its Yield Target", dated February 13, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Heightening geopolitical tensions between the U.S. and China, higher U.S. bond yields, tightening U.S. dollar liquidity and weakening EM/China growth - all combined - constitute a bitter cocktail for EM. Barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. U.S. banks are not creating new dollars sufficiently. In addition, they are shrinking their claims on EM. The U.S. dollar is primed for another upleg. Downgrade Indian stocks from overweight to underweight within a dedicated EM equity portfolio. Feature As China becomes more assertive and slightly hostile toward the U.S., this will likely mark a paradigm shift in the macro landscape and asset valuations and, hence, could become a grey swan1 event for emerging markets (EM). Investors remain complacent about the ongoing geopolitical confrontation between these two economic giants as well as other headwinds that China and EM are facing. The decision by the Trump administration to raise import tariffs to 25% on $200 billion of China's exports to the U.S. as of January 1, 2019 is an unambiguous signal that U.S. trade confrontation with China is not a pre-mid-term election political plot. Instead, it is the beginning of a long-term geopolitical battle between an existing and rising superpower. Remarkably, the just-concluded trade deal between the U.S., Mexico and Canada (USMCA) includes language that requires signatories to give notice if they plan to negotiate a free trade deal with a "non-market" economy.2 Provided "non-market" country is for now implied to be China, this corroborates that confrontation with the latter is a new long-term strategy for the U.S. In addition, investors should not expect China to be constantly on the defensive. Both the political leadership and people in China have realized that trade is not the only aspect where the U.S. is likely to challenge the Middle Kingdom, and they recognize it will be a long-term battle. Therefore, the communist party and President Xi will counter the U.S. with reasonably tough actions. Quite simply, failure to do so will place the political leadership's credibility in question. President Xi understands this well, and will not allow it to happen. It is hard to forecast the avenues and approaches that Chinese leadership will explore to confront the U.S. Yet the recent navy incident in the South China Sea exemplifies that China will not be silent in this row.3 More generally, EM financial markets are not ready for such negative surprises. For example, there has been little capitulation on the part of asset managers with respect to EM equities. In fact, they have lately been buying EM ETF futures (Chart I-1). Global financial market volatility calculated as an equally weighted average of volatility in U.S. and EM equities, U.S. bonds, various currencies, oil and gold are near its historic lows (Chart I-2). Chart I-1Asset Managers Have Been Buying EM Equity Futures Chart I-2Financial Markets Volatility Is Very Low Remarkably, the U.S. bond market volatility is at an all-time low while bond yields are breaking out (Chart I-3). Odds are the U.S. yields will move up considerably. The basis is that strong growth and rising inflation in the U.S. warrant considerably higher bond yields and more Fed rate hikes than are currently priced in. Barring a meaningful improvement in Chinese growth and global trade, higher U.S. bond yields will be overwhelming for EM financial markets. In particular, higher U.S interest rates could trigger another downleg in the value of Chinese yuan. Chart I-4 illustrates that the China-U.S. interest rate differential has been instrumental to moves in the RMB/USD exchange rate. Chart I-3A Breakout In U.S. Bond Yields Chart I-4China Vs. U.S.: Does Interest Rate ##br##Differential Explain Exchange Rate? Apart from the heightening geopolitical tensions between the U.S. and China and higher U.S. bond yields, weakening EM/China growth, tightening global U.S. dollar liquidity and a strong U.S. dollar all combined will constitute a bitter cocktail for EM. We discuss some of these negatives below. All in all, financial markets could be on the cusp of a volatility outbreak, and EM will still be at the epicenter of the storm. BCA's Emerging Markets Strategy service continues to recommend short positions in EM risk assets and an underweight allocation versus DM. A Dead Cat Bounce... Emerging markets share prices have attempted to stage a rebound lately, but so far it appears to be nothing more than a dead cat bounce. Even thought the aggregate EM equity index managed a 5% bounce in recent weeks, both the EM equally weighted equity and small-cap indexes have failed to rebound at all (Chart I-5, top and middle panels). Similarly, EM bank stocks - which make up 17% of the MSCI market cap and are the key to the benchmark's performance - have not rallied (Chart I-5, bottom panel). This is occurring at a time when the S&P 500 is at all-time highs. These are very unhealthy signs for EM risk assets. ...As China/EM Growth Continues To Downshift The premise behind the lack of meaningful rebound in EM equities in our view is that both global manufacturing and world trade growth continue to downshift (Chart I-6, top panel). The epicenters of the slowdown are China and other emerging economies (Chart I-6, middle and bottom panels). Chart I-5No Confirmation Of EM Rebound Chart I-6EM/China Growth Is Decelerating Importantly, the Markit PMI manufacturing surveys suggest export orders contracted in September in the world's important manufacturing hubs, including China, Japan, Taiwan and Germany. The last time such poor export performance was registered was more than two years ago. The slump in the aggregate EM manufacturing PMI explains not only the EM equity selloff but also EM credit spreads widening and EM currency depreciation since the beginning of this year (Chart I-7). So long as the weakening trend in EM/China and global trade growth persist, EM risk assets and currencies will continue to sell off. Regarding China, growth deceleration was already occurring before the initial import tariffs took hold. Specifically, not only are overseas orders weak, but also domestic orders have rolled over decisively, as indicated by the People's Bank of China's (PBoC) 5000 industrial enterprise survey (Chart I-8). Chart I-7Weakening Growth Explains Selloff In ##br##EM Credit And Currencies Chart I-8China: Domestic And Overseas Orders In the mainland, the boost to infrastructure spending in the coming months will likely be offset by a slump in property construction and other segments of the economy. We discussed this angle in our recent report,4 but in recent days there has been more real estate market tightening. Specifically, the authorities are considering the cancellation of the housing pre-sale system in Guangdong province - a policy that could be applied to other geographies. The motive of this tightening is to curb both the land-buying frenzy and Ponzi financing schemes that many developers are involved in. This fits the policy script of dealing with and purging speculation and excesses early to prevent a bust later. These policy measures will cut off property developers from their primary source of funding - presales - and force them to reduce their construction volumes. As an unintended consequence of this announcement, some developers have already begun cutting house prices to accelerate pre-sales and raise funds. Given already bubbly property valuations and the existence of substantial speculative buying, house price deflation could set off a domino chain effect of lower prices, reduced speculative investment purchases and financial strains on developers, leading them in turn to offer even larger price discounts to generate funds faster, and so on. Forecasting the exact trajectory of a downturn and the speed of its adjustment is impossible. This is why we focus on the presence of major imbalances/excesses and policy tightening that could cause disentangling of these excesses. Given the still-considerable property market excesses5 prevalent in China and the money/credit tightening that has already occurred in the past two years, we reckon the odds of a material property market downtrend are substantial. On the whole, our main theme for China and EM remains that mainland construction activity will continue to downshift, with negative implications for countries that supply construction goods, materials and equipment. U.S. Dollars Shortages? The U.S. economy is firing on all cylinders and inflationary pressures continue to rise. Barring a deflationary shock from China/EM, the Federal Reserve has little reason to halt its rate hikes or abandon its policy of shrinking its balance sheet. Not only are U.S. interest rates rising, but there are also budding U.S. dollar shortages that will get worse: The U.S. banking system's excess reserves at the Fed are dwindling, as the latter continues to shrink its balance sheet (Chart I-9). U.S. banks' dollar-denominated claims on foreign entities in general and emerging markets in particular are shrinking (Chart I-10). Thus, EM debtors in particular have found themselves short of dollars. Chart I-9The U.S. Dollar Is Primed For Another Upleg Chart I-10U.S. Dollar Shortages In Rest Of World Finally, U.S. banks are not creating enough dollars - their total assets are growing at a paltry rate of 1%, and U.S. broad money (M2) growth is expanding at 4% annually - the slowest pace in the past 14 years excluding the aftermath of the 2008 credit crisis (Chart I-11). Bottom Line: The Fed is shrinking its balance sheet, and high-powered money/liquidity in the banking system is falling. This and other factors are discouraging U.S. banks from creating new U.S. dollars. Along with rising U.S. interest rates, this will propel the greenback higher, which will be detrimental for EM risk assets. Equity Portfolio Rotation Amid High Oil Prices Given the recent breakout in oil prices, we make the following changes to our country equity allocation: Upgrade Russia from neutral to overweight.4 October 2018 Orthodox macro policy and high oil prices will help this bourse to outperform the EM benchmark (Chart I-12, top panel). We have already been overweight Russia within EM local bonds, currency and credit portfolios.6 Chart I-11U.S. Banks Are Not Creating Sufficient Amount Of Dollars Chart I-12Upgrade Russian And Colombian Equities ##br##From Neutral To Overweight Upgrade Colombian equities from neutral to overweight. Like Russia, high oil prices and orthodox macro policies justify an upgrade (Chart I-12, bottom panel). Upgrade Malaysia from underweight to neutral.4 October 2018 High energy prices, hope for structural changes and low inflation do not justify an underweight stance. Still, Malaysia is vulnerable to slowdown in global trade and credit excesses of the past years that have not yet been worked out. This prevents us from upgrading this bourse to overweight. Downgrade Philippines equities from neutral to underweight.4 October 2018 Inflation is breaking out and the central bank is behind the curve.7 Downgrade India from overweight to underweight. More detailed analysis on India starts on the following page. Our equity overweights are Taiwan, Korea, Thailand, Chile, Mexico, Colombia, Russia and central Europe. Our underweights are Brazil, South Africa, India, the Philippines, Indonesia and Peru. The complete list of our equity, fixed-income, credit and currency allocations are always presented at the end of our Weekly Reports, please refer to page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrade Indian Equities 4 October 2018 We are downgrading our allocation to Indian stocks from overweight to underweight within an EM-dedicated equity portfolio (Chart II-1). Rising stress in the country's non-bank finance companies - the recent default of finance company Infrastructure Leasing & Financial Services Limited and the fire-sale of Dewan Housing Finance bonds by a mutual fund - has been responsible for escalating financial risks, and will have ramifications for overall macro stability and growth. Stress Among Finance Companies: Liquidity Or Solvency? Finance companies account for about 12% of the MSCI India Stock Index. Further, there are deep interlinkages between them and mutual funds. Chart II-2 shows that mutual funds have exponentially increased their claims on non-bank finance companies by purchasing commercial paper (short-term debt obligations) issued by the latter. Chart II-1Failure To Break Out Is A Bad Omen Chart II-2Mutual Funds' Exposure To Finance Companies Further signs that the non-bank finance sector is having difficulties rolling over or repaying their debt obligations will hurt mutual funds. This might trigger redemptions from the latter by their own investors. Importantly, mutual funds' net purchases of equities as well as bonds has been very strong in recent years, often outpacing that of foreigners (Chart II-3). Given the former's large holdings of various securities, forced selling by mutual funds can often create an air pocket for Indian financial markets: local investors will be selling at a time when foreign investors are not yet ready to buy. Odds are considerable that stress will continue to escalate in the non-bank financial sector. Short-term interest rates and corporate bond yields are rising (Chart II-4). This is occurring at a time when non-bank finance companies are very vulnerable because of their liquidity mismanagement. Chart II-3Indian Mutual Funds Are Large Investors In Stocks And Bonds Chart II-4Rising Borrowing Costs Financial data from six non-bank finance companies included in the MSCI India Equity Index reveals that short-term debt levels for these companies are extremely elevated (Chart II-5, top panel) and their liquidity situation is grim. A measure of liquidity risk, calculated as short-term investments (including cash) minus short-term borrowing, has plummeted and is in deep negative territory (Chart II-5, bottom panel). In short, these finance companies have been borrowing short term and lending long term. Additionally, these entities will soon have to deal with surging non-performing assets (NPAs). Total assets for large finance companies - including the six companies included in the MSCI Equity Index - have grown at an annual average of around 20% since 2010. It is difficult to lend or invest at such a rapid pace while avoiding capital misallocation and the accumulation of bad assets. Crucially, the current level for NPAs for these six finance companies is 2.3% of risk-weighted assets, but could rise much further. Their provisions stand 2.1%, which barely covers existing NPAs. Hence, provisions have to rise multi-fold. For example, if NPAs rise to 12%, that would wipe out 32% of these companies' equity. We assume a recovery ratio of 30% on these bad assets. For comparison, the NPA ratio for overall the banking system has already surged to about 12%. Finally, commercial banks' lending to finance companies has been excessive in recent years (Chart II-6). Commercial banks are already swamped with rising non-performing loans, and any additional stress among finance companies will damage investor sentiment and negatively impact banks' share prices. Chart II-5Finance Companies: Liquidity Strains Are ##br##Rooted In Maturity Mismatches Chart II-6Banks' Exposure To Finance Companies Bottom Line: Odds are that the liquidity stress among finance companies will escalate and turn into a solvency problem. This will harm mutual funds in particular and cause them to liquidate their equity and bond holdings. Indian financial markets will selloff further. Limited Maneuvering Room For Central Bank High crude prices, rising inflation and mounting financial stress are placing the Reserve Bank of India (RBI) in an extremely precarious position: If the central bank provides sufficient liquidity or reduces interest rates to deal with budding stress in the financial system, the currency will plunge further; If the RBI does not provide sufficient liquidity or hikes rates to put a floor under the rupee, the stress in the financial system will worsen. It seems the central bank is currently biased to providing liquidity to contain financial system stress. In fact, the central bank has already injected bank reserves through the liquidity adjustment facility. In addition, it announced upcoming purchases of government securities in October in the order of Rs. 360 billion and has stressed its willingness to provide more injections if the need arises. This is negative for the currency which will continue to tumble, especially at a time when the U.S. dollar is well-bid worldwide. In turn, continued currency depreciation will make foreign investors net sellers of stocks and bonds. Bottom Line: We recommend investors downgrade India from overweight to underweight. We are also closing our long Indian banks / short Chinese banks at a 2% loss. Concerning equity sectors, we are reiterating our long Indian software companies' stocks / short EM overall equity benchmark. This trade is up 22%, and a cheaper rupee and strong DM growth herald further gains. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 A grey swan is an event that can be anticipated to a certain degree but is considered unlikely to occur and would have a sizable impact on financial markets if it were to occur. 2https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement/united-states-mexico# 3https://www-m.cnn.com/2018/10/01/politics/china-us-warship-unsafe-encounter/index.html?r=https%3A%2F%2Fwww.cnn.com%2F 4 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, a link available on page 16. 5 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?," dated April 6, 2018, available on ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report "Vladimir Putin, Act IV," dated March 7, 2018, link available on ems.bcaresearch.com. 7 Please see Emerging Markets Strategy Special Report "The Philippines: Duterte's Money Illusion," dated April 25, 2018, link available on ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? Go long Brent / short S&P 500. The risk of a recession in 2019 is underappreciated. Why? The likelihood is increasing of a geopolitically-induced supply-side shock that pushes crude prices above $100 per barrel in the coming 6-12 months. Oil supply disruptions in Iran, Iraq, and Venezuela represent the primary source of risk. Historically, the combination of Fed rates hike and an oil price spike has preceded 8 out of the last 9 recessions. Also... A recession in 2019, ahead of the 2020 election, would set the stage for a confrontation between Trump and the Fed, adding fuel to market volatility. Feature Geopolitical tensions are brewing from the Strait of Hormuz to the Strait of Malacca. As we go to press, news is breaking that a Chinese naval vessel almost collided with the USS Decatur as the latter conducted "freedom of navigation" operations within 12 nautical miles of Gaven and Johnson reefs in the Spratly Islands. Given the trade tensions between China and the U.S., this alleged maneuver by the Chinese vessel suggests that Beijing is not backing off from a confrontation. Our view remains that Sino-American trade tensions can get a lot worse before they get better. The latest incident, which builds on a series of negative gestures recently in the South China Sea, suggests that both sides are combining longstanding geopolitical tensions with the trade war. This will likely encourage brinkmanship and further degrade U.S.-China relations. Yet China-U.S. tensions are not the only concern for investors in 2019. Another crisis is brewing in the Middle East, with the potential to significantly increase oil prices over the next 12 months. U.S. households may have to deal with a double-whammy next year: higher costs of imported goods as the U.S.-China trade war rages on and a significant increase in gasoline prices. In this report, we discuss this dire outlook. The Folly Of Recession Forecasting In mid-2017, BCA Research published two reports, one titled "Beware The 2019 Trump Recession" and another titled "The Timing Of The Next Recession."1 Both argued that if the Federal Reserve kept raising rates in line with the FOMC dots, then monetary policy would move into restrictive territory by early 2019 and increase the likelihood of recession thereafter. We subsequently adjusted the timing of our recession forecast to 2020 or beyond, based on a more positive assessment of the U.S. economy. In this report, we explore a risk to the BCA House View on the timing of the next recession. As BCA's long-time Chief Economist Martin Barnes has said, predicting recessions is a mug's game. There have been eight recessions in the past 60 years (excluding the brief 1980-81 downturn) and the Fed failed to forecast all of them (Table 1). Table 1Fed Economic Forecasts Versus Outcomes The Atlanta Fed produces a recession indicator index which is designed to highlight the odds of recession based on trends in recent GDP data. At the moment, the indicator is at a historically sanguine 2.4%. Unfortunately, low readings are not a reliable cause for optimism. The 1974-75, 1981-82, and 2007-09 recessions were all severe and the Atlanta Fed's recession indicator had a low reading of 10%, 1.6%, and 7.7%, respectively - just as the recession was about to begin (Chart 1). Chart 1The Market Is Not Expecting A Recession The 1974-75 recession is instructive, given the numerous parallels with the current environment: Energy Geopolitics: The 1973 oil crisis caused a massive spike in crude prices. This point is especially pertinent since the 1973 oil embargo is widely viewed as an important contributor to the 1974-75 recession. Real short rates had risen and the yield curve had inverted long before oil prices spiked, so recession was almost inevitable even without the oil price move. But the oil spike made the recession much deeper than otherwise. Protectionism: President Nixon imposed a 10% across-the-board tariff on all imports into the U.S. in 1971 to try to force trade partners to devalue the U.S. dollar. Dislocation: Competition from newly industrialized countries - Japan and the East Asian tigers in particular - laid waste to the steel industry in the developed world. Polarization: President Nixon polarized the nation with both his policies and behavior, leading to his resignation in 1974. Given the exogenous and geopolitical nature of oil supply shocks, today's recession indicators are missing a critical potential headwind to the economy. A geopolitically induced oil-price shock could create more pain than the economy is able to handle. Why An Oil Price Shock? America's renewed foray into the politics of the Middle East will unravel the tenuous equilibrium that was just recently established between Iran and its regional rivals. The U.S.-Iran détente that produced the signing of the 2015 Joint Comprehensive Plan of Action (JCPA) created conditions for a precarious balance of power between Israel and Saudi Arabia on one side, and Iran and its allies on the other side. This equilibrium led to a meaningful change in Tehran's behavior, particularly on the following fronts: The Strait of Hormuz: Tehran ceased to rhetorically threaten the Strait as soon as negotiations began with the U.S. (Chart 2). Since then, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities remain unchanged.2 Iraq: Iran directly participated in the anti-U.S. insurgency in Iraq. Tehran changed tack after 2013 and cooperated closely with the U.S. in the fight against the Islamic State. In 2014, Iran acquiesced to the removal of the deeply sectarian, and pro-Iranian, Prime Minister Nouri al-Maliki. Bahrain and the Saudi Eastern Province: Iran's material and rhetorical support was instrumental in the Shia uprisings in Bahrain and Saudi Arabia's Eastern Province in 2011 (Map 1). Saudi Arabia had to resort to military force to quell both. Since the détente with the U.S. in 2015, Iranian support for Shia uprisings in these critical areas of the Persian Gulf has stopped. Chart 2Geopolitical Crises And Global Peak Supply Losses Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Put simply, the 2015 nuclear deal traded American acquiescence toward Iranian nuclear development in exchange for Iran's cooperation on a number of strategically vital regional issues. By unraveling that détente, President Trump is upending the balance of power in the Middle East and increasing the probability that Iran retaliates. Since penning our latest net assessment of the U.S.-Iran tensions in May, Iran has already retaliated.3 Our checklist for "kinetic" conflict has now risen from zero to at least 15%, if not higher (Table 2). We expect the probability to rise once the U.S. starts implementing the oil embargo in November. This will dovetail our Iran-U.S. decision tree, which sets the subjective probability of kinetic action by the U.S. against Iran at a baseline of 20% (Diagram 1). Table 2Will The U.S. Attack Iran? Diagram 1Iran-U.S. Tensions Decision Tree Bottom Line: The premier geopolitical risk to investors in 2019 is that President Trump's maximum pressure tactic on Iran spills over into Iraq, causing a loss of supply from the world's fifth-largest crude producer.4 We expect the U.S. oil embargo against Iran to remove between 1 million and 1.5 million barrels per day from the market. In addition, the loss of Iraqi production due to sabotage could be anywhere between 500,000 and 3.5 million barrels per day. Added to this total is the potential loss of Venezuelan exports due to the deteriorating situation there. When our commodity team combines all of these factors, they generate a worst-case scenario where the price of crude rises to $110 per barrel in 2019 or higher (Chart 3). And this scenario assumes that EMs do not reinstitute energy subsidies (and therefore their consumption falls faster than if they do reinstitute them). Chart 3Worst-Case Scenario Propels Oil Price Toward 0/Barrel The Ayatollah Recession We believe that the midterm election is a dud from an investment perspective, no matter the outcome. However, the election does matter as a hurdle that, once cleared, will allow President Trump to renew his "maximum pressure" tactic against China, Iran, and perhaps domestic tech corporations.5 Iran is a critical risk in this strategy. If President Trump applies maximum pressure on Iran, then a reduction in crude exports from Iran, Iranian retaliation in Iraq, and the simultaneous loss of Venezuelan supplies could combine to increase the likelihood of U.S. recession in 2019. Readers might recall that no sitting president has gotten re-elected during a recession. Why would Trump pursue a policy that risks his re-election chances in 2020? Surely he would deviate from his maximum pressure tactic if faced with the prospect of a recession. However, it is folly to assume that policymakers are perfectly rational, or fully informed. American presidents are some of the most unconstrained policymakers in the world, given both the hard power of the United States and the constitutional lack of constraints on the president when it comes to national security. Trump may believe, for instance, that the 660 million barrels of crude in America's Strategic Petroleum Reserve can offset the impact of sanctions against Iran.6 Or he may believe that he can force OPEC to supply enough oil to offset the Iranian losses. The problem for President Trump is that Iran is not led by idiots. Iranian policymakers understand that the best way to reduce American pressure is to induce an oil price spike in the summer of 2019 that hurts President Trump's re-election chances, forcing him to back off. As such, sabotaging Iraqi oil exports, which mainly transit through the port of Basra - a city highly vulnerable to Shia-on-Shia violence that is already a risk to the country's stability - would be an obvious target. An oil price spike would serve as a negotiating tool against the U.S., and the additional revenue would help replace what Iran loses due to the embargo. Tehran and Washington will therefore play a game of chicken throughout 2019, and there is a fair probability that neither side will swerve. President Trump may be making the same mistake as many predecessors have made, assuming that the Iranian regime is teetering at a precipice and that a mere nudge will force the leadership to negotiate. Oil price shocks and recessions have a historical connection. In a recent report, our commodity strategists highlighted that a spike in oil prices preceded 10 out of the past 11 recessions in the U.S. since 1945 (Table 3). Admittedly, not all spikes were followed by recession. The combination of an oil price spike and Fed rate hikes has produced a recession 8 out of 9 times.7 If oil prices rose to $100 per barrel in the coming 6-12 months, there will be several negative macro consequences. In particular, gasoline prices will rise back toward $4 per gallon (Chart 4). Retail gasoline prices have already increased by more than 50% since they bottomed in February 2016. So how much more upside can the U.S. private sector take? Table 3History Of Oil Supply Shocks Chart 4A Source Of Pressure For Consumers The Household Sector Consumer confidence is currently near all-time highs, which tends to signal that the path of least resistance is flat or down (Chart 5). Household gasoline consumption has already declined in response to higher oil prices since the middle of 2017. Given that gasoline demand is relatively inelastic, consumers may already be near their minimum consumption level. Chart 5Nearing All-Time Highs Instead, households will experience a decline in their disposable income. This will come on the back of both higher gasoline prices and an increase in the prices of other goods and services, as the oil spike spills across sectors. U.S. households - and most likely those in other markets - are stretched to the limit already. A recent Fed survey found that 40% of U.S. households do not have the funds needed to meet an unexpected $400 cost in any given month.8 Such an unexpected expense would require them to either sell possessions, borrow, or cut back on other purchases. Chart 6Most Americans Cannot Cut Saving To Spend Left with few other options, households would react to their lower disposable income by reducing demand for other goods and services. This dent in consumer spending would bring down aggregate demand, leading to slower employment growth and even less income and spending. Households could save less to maintain their current purchasing levels, given the recent rise in the savings rate (Chart 6). But this is unlikely. Although the household savings rate has increased in recent years, we have previously argued that a material part of the increase was driven by small business-owner profits. These owners have much higher levels of income than the median consumer. For Americans living paycheck-to-paycheck, it would be difficult to reduce a savings rate that is already close to, or below, zero. Higher oil prices will also hurt growth in Europe and Japan, economies that are already struggling to gain economic momentum after grappling with a weaker growth impulse from China. In addition, EM economies that took the opportunity to reform their oil subsidies amid lower oil prices post-2014 will have to grapple with a much larger shock to consumers than usual. The Corporate Sector In theory, what consumers lose from rising oil prices, producers of crude can gain in stronger revenue. This is especially important in the U.S. as domestic energy production has increased significantly over the past 10 years. Nonetheless, the oil and gas extraction sector accounts for just 1.1% of GDP and 0.1% of total employment. The marginal propensity to spend out of every dollar of income is lower for producers than consumers. Moreover, if consumer confidence fell and consumer spending weakened, non-energy capex would decline as businesses reassessed household demand and held off from making investment decisions. Small business confidence is at record highs, and as with consumer confidence, vulnerable to downward revisions (Chart 7). Chart 7Dizzying Heights Chart 8Only One Way To Go (Down) Profit margins remain at a highly elevated level and also have only one way to go (Chart 8). If high oil prices should combine with rising borrowing costs and upward pressure on wages (which could develop in this macro environment) the result would be a triple hit to margins (Chart 9). Of course, rising wages would give consumers some offset to higher oil prices, so the question will be the net effect of all variables. And if the dollar bull market continues, as our FX team believes it will, the combination of higher oil prices and a strong USD would hurt U.S. companies with international exposure. The debt load held by the U.S. corporate sector would turn this bad dream into a nightmare. Many American companies have spent the past 10 years increasing leverage to buy back equity (Chart 10). Companies with high debt would need to revise down their profit expectations, with potentially devastating consequences. Elevated debt levels also increase the likelihood of financial market stress if bond investors get worried and spreads begin to widen significantly. Chart 9Rising Pressures On Earnings? Chart 10Large Corporate Debts According to all measures, U.S. stocks are at or near their all-time valuation peaks. Investors have also priced in a significant amount of optimism for profit growth (Chart 11). These expectations would be subject to quick revision if our oil shock scenario plays out. In other words, investor expectations for profit margins are not sufficiently factoring the triple hit of higher oil prices, higher interest rates, and higher wages. Chart 11The Market Has High Hopes An additional geopolitical risk on the horizon for 2019 is the creeping "stroke of pen" risk from potential regulation of technology enterprises. This is unrelated to an oil price spike (other than that it would be an effect of U.S. policy) but could nonetheless combine with rising energy prices to sour investors' mood.9 Bottom Line: An oil price spike above $100 would produce negative consequences for the U.S. household and corporate sectors. Given the supply-side nature of the price shock, it would not be accompanied by the usual decline in USD, and could therefore hurt the foreign profits of U.S. corporations as well. If investors must also deal with mounting regulatory pressures on FAANG stocks, they could face a perfect storm. Given the high probability of such an oil price shock, why isn't a 2019 recession BCA's House View, rather than merely a risk to it? Because it is difficult to say how high oil prices need to rise to cause a recession. For example, 1973 both marked a permanent move up in oil prices and saw oil prices triple. In 2019 terms, that would mean an oil price above $200, a far less probable scenario than $100-$110. Nevertheless, the combination of elevated oil prices and the price impact on consumer goods of the U.S.-China trade war could combine to create a nightmare scenario for consumers. But it is impossible to gauge the level of both required to push the U.S. into a recession. Second, there are many ways in which today's macro environment is different from that in 1974. In the 1970s the inventory cycle was a key factor in the business cycle, with excesses building up ahead of recessions, forcing output cutbacks as demand weakened. That is no longer the case in today's world of just-in-time inventory management. Also, inflation was a much bigger problem back then, requiring tougher Fed action. On the other hand, debt burdens were much lower. Investment Implications To be clear, none of the usual recession indicators that BCA Research uses are flashing red at this time. The point of this analysis is to illustrate a credible, exogenous scenario that cannot be revealed through the usual data-driven recession forecasting methods. What happens if a recession does occur ahead of the 2020 election? How would President Trump react to a recession induced by his foreign policy adventurism in the Middle East? By doing what every other president would do: finding someone else to blame. In this case, we would put high odds on the Federal Reserve becoming the target of President Trump's fury. Ahead of 2020, the Fed and its independence may very well become an election issue.10 This could spell serious trouble for the Fed, which is at a massive disadvantage when it comes to explaining to voters why central bank independence is so important. The Fed had great difficulty managing public opinion regarding its extraordinary measures to combat the Great Recession - its attempts at public outreach largely failed. Compare the number of Trump's Twitter followers to that of the Fed's (Chart 12). Chart 12The Fed's PR Abilities Are Limited Though most of our clients and colleagues will probably disagree, we do not see central bank independence as a static quality. It was bestowed upon central banks by politicians following widespread inflation fears throughout the 1970s and 1980s, although in the U.S. the current tradition goes back to the 1951 Treasury Accord that restored the independence of the Fed. Our colleague Martin Barnes penned a report on the politicization of monetary policy in 2013.11 His conclusion is that political meddling in monetary affairs is less pernicious than economic performance. The Fed will incur Trump's ire, in other words, but it will be its failure to generate economic growth that causes a break in independence. We are not so sure. The next recession is likely to be a mild one for Main Street given the lack of real economic bubbles. But given the slow recovery in real wages over the past decade and the general angst of the populace towards governing elites, even a mild recession that merely reminds voters of 2008-2009 could produce deep anxiety and significant public reactions. Further, the idea of "independent," non-politically accountable institutions is going out of style. President Trump - and other policymakers in the developed world - have specifically targeted the "so-called experts" and "institutions." President Trump has attacked America's foreign policy architecture, NATO, the WTO, and a slew of supposedly outdated norms and practices for being "out of touch" with the electorate. This policy has served him well thus far. If our nightmare scenario of an oil price-induced recession plays out, the immediate implication for investors will be a sharp downturn in risk assets. As such, we are recommending that investors hedge their portfolios with a long Brent / short S&P 500 trade. Alternatively we would recommend going long U.S. energy / short technology stocks. A longer-term, and perhaps even more pernicious implication, would be the end of the era of central bank independence and a full politicization of the economy. Laissez-faire capitalist system would give way to dirigisme. In the process, the U.S. dollar and Treasuries would be doomed. Jim Mylonas, Global Strategist Daily Insights & BCA Academy jim@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 3 Please see BCA Research Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018 and "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com. 6 The Strategic Petroleum Reserve currently covers 100 days of net crude imports, or 200 days of net petroleum imports, and can be tapped for reasons of political timing as well as international emergencies. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," dated September 13, 2018, available at bcaresearch.com. 8 Please see the U.S. Federal Reserve, "Report on the Economic Well-Being of U.S. Households in 2017," May 2018, available at federalreserve.gov. 9 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com. 10 Please see BCA Daily Insights, "Politics And Monetary Policy," dated August 22, 2018, and "The Battle Of The Press Conferences: Trump Versus Powell," dated September 27, 2018, available at dailyinsights.bcaresearch.com. 11 Please see BCA Special Report, "The Politicization Of Monetary Policy: Should We Care?" dated April 15, 2013, available at bca.bcaresearch.com. Geopolitical Calendar

Highlights Recommended Allocation We don't see any change over the next six to 12 months to the current trends of strong U.S. growth, continuing Fed hikes, rising long-term interest rates, and an appreciating dollar. We stay neutral on global equities and continue to favor the U.S. and, to a degree, Japan. Given rising rates, a strengthening dollar, ongoing trade war and moderate slowdown in China, we expect EM assets to sell off further. We forecast the 10-year U.S. Treasuries yield to rise to 3.5% by H1 2019, and so we stay underweight fixed income, short duration, and continue to prefer TIPs. We are only neutral on credit within the (underweight) fixed-income bucket. We shift our equity sector weightings to reflect the GICS recategorization. We recommend a neutral on the new internet-heavy Communication sector, and underweight on Real Estate. We have a somewhat defensive sector bias, with overweights in Consumer Staples and Healthcare. Alternative risk assets, such as private equity and real estate, look increasingly overheated. We prefer hedge funds and farmland at this stage of the cycle. Overview More Of The Same When there's been a strong trend, it's always tempting to be contrarian and argue for a reversal. Tempting but, at the moment, we think wrong. This year has been characterized by a strong U.S. economy but slowing growth elsewhere, the outperformance of U.S. equities (up 10% year-to-date, compared to a 4% decline in the rest of the world), rising U.S. interest rates, dollar appreciation, and a big sell-off in emerging markets. While a short-term correction is always possible, we don't see a fundamental end to these trends over the next 6 to 12 months. Chart 1U.S. Growth Still Looks Strong Chart 2Growth In Europe And Japan Has Slipped U.S. growth is likely to remain strong. Consumer and business sentiment are both close to record highs; wage growth is beginning (finally) to accelerate; capex intentions are buoyant; and fiscal stimulus will add 0.7% to GDP growth this year and 0.8% next, as the budget deficit widens to close to 6% of GDP (Chart 1). Europe and Japan, by contrast, have slowed this year: both are more exposed to emerging markets than is the U.S.; fiscal policy in neither is particularly accommodative; and European banks suffer from weak loan growth and their EM exposure (Chart 2). The one trigger that would cause global ex-U.S. growth to accelerate relative to U.S. growth is a massive stimulus in China similar to 2009 and 2015. We think this unlikely because the authorities have reiterated their commitment to deleveraging and structural reform. Chinese credit growth and money supply data have as yet shown no signs of picking up, but they should be monitored carefully (Chart 3). Chart 3Chinese Stimilus, What Stimilus? Chart 4Republicans Like Trump's Tough Trade Talk An end to the trade war might also reverse the trends. U.S. markets have shrugged off the risk of escalating retaliatory tariffs on the (reasonable) grounds that trade has relatively little impact on the U.S. It is hard to see an end-game to the tariff war. President Trump's popularity has risen since he got tough on trade (Chart 4). He has changed his mind on many areas of policy during his career, but he's always consistently argued that the U.S. deficit shows that its trading partners treat it unfairly. The probability is high that the 10% tariff on $200 billion of Chinese goods will rise to 25% in January, and is eventually extended to all Chinese imports. It is equally unlikely that Xi Jinping will make concessions, since he can't be seen to bend to U.S. pressure and won't put at risk the crucial "Made in China 2025" plan. Chart 5Phillips Curve Working Again Although tariffs may not hurt U.S. growth much, they could be inflationary. The price of washing machines, the subject of the earliest tariffs in January, rose by 18% over the next four months. This is just another reason why it's unlikely that the Fed will slow its pace of rate hikes. With the labor market now clearly tight, there are signs that the Phillips curve is beginning to reassert itself (Chart 5), and wage growth is accelerating. With core PCE inflation at its 2% target and the impact of fiscal stimulus still coming through, the Fed will feel comfortable about maintaining its current schedule of one 25 basis point hike a quarter until there are signs that the economy is slowing.1 Could the sell-off in emerging markets cause the Fed to move to hold? In the 1990s Asia Crisis, only when the fall in Asian stocks started to affect the U.S. economy (with, for example, the manufacturing ISM going below 50) and the U.S. stock market, did the Fed ease policy (Chart 6). Eventually, the slowdown in the rest of the world might start to hurt the U.S. In the past, when the global ex-U.S. Leading Economic Indicator has fallen below zero, it has usually been followed by U.S. growth also faltering (Chart 7). Chart 6In 1998, Fed Cut Only When EM Hurt The U.S. Chart 7When The World Slows, Often U.S. Does Too Table 1What To Watch For Having in June lowered our recommendation on global equities to neutral (but keeping our overweight on U.S. stocks), we continue to monitor the factors that would make us turn negative on risk assets (Table 1 and Chart 8). None of them is yet flashing a warning signal, but it seems likely that we will need to move to an outright defensive stance sometime in H1 2019. One final key thing to watch: any signs that U.S. earnings growth is slipping. Much of the outperformance of U.S. equities this year is simply explained by better earnings growth, partly due to the tax cuts. Analysts' forecasts for 2019 have so far been very stable. If they start to be revised down, perhaps because of higher wages and export sales being dampened by the strong dollar, that would also be a signal to switch out of U.S. equities (Chart 9). Chart 8What To Watch For? Chart 9Will Analysts Revise Down EPS Forecasts? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Is The Fed Turning Dovish? Chart 10Fed Policy Still Accomodative Many investors interpreted Fed Chair Powell's speech at Jackson Hole in August dovishly. Powell questioned whether "policymakers should navigate by [the] stars": r* (the neutral rate of interest) and u* (the natural rate of unemployment), since these are uncertain. He emphasized that policy will be data dependent. We read it differently. Powell also pointed out that "inflation is near our 2 percent objective, and most people who want a job are finding one", and concluded that a "gradual process of normalization remains appropriate". A speech in September by Lael Brainard, a dovish FOMC member, reinforced this. She separated the long-run neutral rate (the terminal rate in the Fed dot plot) from the short-term neutral rate (Chart 10, panel 1). Her conclusion was that "with fiscal stimulus in the pipeline and financial conditions supportive of growth, the shorter-run neutral interest rate is likely to move up somewhat further, and it may well surpass the long-run equilibrium rate." In other words, the Fed needs to continue its gradual pace of hikes. The market does not see it that way. Futures markets have priced in that the Fed will raise rates until June (when the Fed Funds Rate will be 2.75-3% in nominal terms) and then stop (panel 2). But this implies that the Fed will halt once the FFR is at the (current estimate of the) neutral rate. But inflation is likely to pick up further over the next 12 months. And the Fed is worried that, despite rate hikes, financial conditions haven't tightened much (panel 3). So we expect the Fed to keep tightening until there are signs that growth is slowing. Is The Worst Over For Emerging Markets? Chart 11Excess Debt Is Underlying Cause Of EM Sell-Off Since the plunge in the Argentinian peso and Turkish lira, currencies in most emerging markets have fallen sharply. Does this present a buying opportunity for investors, or is there more contagion to come? While a short-term rebound is not impossible, we remain very negative on the outlook for most emerging market assets. Fed policy and rising U.S. interest rates can be seen as the trigger for, but not the underlying cause of, the recent sell-off. Since 1980 (Chart 11), there have been only two instances where EM stock prices collapsed amid rising U.S. rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. But both occurred because of poor EM fundamentals. We see similar underlying problems today. EM dollar-denominated debt as a share of GDP and exports is as high as it was during the Asia Crisis in the late 1990s. In addition, the EM business cycle will continue to decelerate in the medium term, as evidenced by falling manufacturing PMIs. Consequently, EM corporate earnings growth is slowing, and we expect it to fall meaningfully in this downturn. EM economies have become increasingly dependent on Chinese growth for their export demand. China is slowing, but we expect limited credit and fiscal stimulus from the authorities given their shift in focus towards de-leveraging and reforming the financial sector. Additionally, global trade is also weakening as seen by falling Asian exports and sluggish container freight movements. EM central banks have responded to currency weakness by raising rates, which in turn will lead to rising local currency bond yields and tightening financial conditions. A tightening of liquidity will slow money and credit creation, ultimately weighing on domestic demand. Moreover, with an accelerating U.S. economy, the U.S. dollar will continue to strengthen, eventually tightening global liquidity. We continue to advocate an underweight position in EM assets. Share prices will not bottom until EM interest rates fall on a sustainable basis, or until valuations reach clearly over-sold levels, which they have not yet. Chart 12The New Sectors Look Very Different What Just Happened To GICS? Following Real Estate's 2016 separation from Financials to become the 11th sector within GICS, September 28 2018 marked an even more disruptive change to equity classification. The change, aimed at keeping up with innovation and the current market structure, affects three of the 11 sectors: Telecommunication Services, Consumer Discretionary, and Information Technology (Chart 12). In short, the Telecommunication Services sector, once a value, low-weight, low-beta, high-yield, defensive sector is broadened and renamed Communication Services, offering broad-based coverage of content on various internet and media platforms. It includes the Media group, as well as selected companies from Internet & Direct Marketing Retail, taken out of Consumer Discretionary. Additionally, selected companies from the Internet Software & Services, as well as Application and Home Entertainment Software move into the new sector from IT. The E-commerce group also grows, with selected companies moving out of IT into Consumer Discretionary. Telecom/Communication, which previously behaved like Utilities, has turned into a high-growth, low-dividend sector. It is also a cyclical rather than defensive. It should trade at much higher multiples than its previous incarnation. IT is also no longer be the same. The sector, which once represented nearly 20% of the ACWI index, has shrunk to 13%, now mostly comprises hardware and software companies, after losing constituents such as Alphabet, Facebook, and Tencent. Chart 13Three Ideas To Enhance Risk-Adjusted Return Where To Find Yield In A Low-Return Environment? BCA's House View in June downgraded equities to neutral and moved cash to overweight. For U.S. investors, holding cash is quite attractive, as the yield on three-month Treasury bills is above 2%, higher than the 1.8% dividend yield on equities. But investors in Europe and Japan face negative yields on cash. Our recent Special Report analyzed three investment instruments that could enhance a balanced portfolio's risk-adjusted returns (Chart 13).2 Floating-Rate Notes. FRNs tend to be issued by government-sponsored enterprises and investment-grade corporations. They offer a nice yield pick-up over short-term U.S. Treasuries with significantly shorter duration. However, they do carry credit risk and so performed poorly in the 2007-9 recession. We, therefore, recommend investors fund these positions from their high-yield bucket. Leveraged Loans. These are floating-rate senior-secured bank loans. However, secured does not mean safe. Most are sub-investment grade and can be very illiquid, because physical delivery is often needed. They tend to be positively correlated with junk bonds but negatively correlated with the aggregate bond index. This suggests that adding bank loans to a portfolio can add diversification, and that replacing some high-yield holdings with bank loans can generate a sub-investment grade basket with a better risk/reward profile. Danish Mortgage Bonds. DMBs are covered mortgage bonds, with an average duration of five years and offering a yield to maturity of around 2% in Danish Krone. They have a strong track record: not a single bond has defaulted in the 200-year history of the market. This makes the market very attractive to euro zone and Japanese investors struggling with low bond yields. We find that adding DMBs to a standard bond portfolio significantly improves its risk/return profile. The main snags are that this is a fairly small market with a total outstanding market value of DKR2.7 trillion (around USD400 billion) - and is already 23% owned by foreigners. Global Economy Overview: The global economy will continue to be characterized by significant divergences. U.S. growth remains robust, pushing up inflation to the Fed's 2% target. By contrast, European and Japanese growth has weakened so far this year, meaning that central banks there remain cautious about tightening. Meanwhile, emerging markets will continue to deteriorate, faced with an appreciating dollar, rising U.S. interest rates, and lack of a big stimulus in China. U.S.: The ISM manufacturing index hit a 14-year high, above 60, in September before falling back slightly, to 59.8, in October. Core PCE inflation has reached 2%, the Fed's target. Wage growth, as measured by average hourly earnings, has finally begun to accelerate, reaching 2.9% YoY. With consumption and capex likely to remain robust, and the effect of fiscal stimulus not peaking until early next year, the U.S. economy will continue to grow strongly through 2019 (Chart 14). Only the recent slowdown in housing (probably caused by higher interest rates) remains a concern, but the sector is probably too small to derail overall economic growth. Chart 14Divergences Continue: U.S. Strong... Chart 15...Rest Of The World Weakening Euro Area: The decline in growth momentum seen since the start of the year has probably now bottomed. Both the PMI and ZEW indexes appear to have stabilized at a moderately positive level (Chart 15, panel 1). Core CPI inflation remains stable at about 1%, though headline inflation has been pushed up by higher oil prices. In this environment the ECB will be slow to raise rates, probably waiting until September next year and then hiking by only 10 basis points. Japan: The external sector has weakened, as shown by the industrial production data and leading economic indicators, probably because of slowing growth in China. However the domestic sector is showing signs of life, with corporate profits growing by more than 20% year-on-year, and capex rising at a rapid pace (6.4% YoY in Q2). However core inflation remains barely above zero, and therefore the Bank of Japan will continue its Yield Curve Control policy for the foreseeable future. Emerging Markets: Chinese growth continues to slow moderately, with the Caixin manufacturing PMI exactly at 50 (Chart 15, panel 3). The key question now is whether the authorities will implement massive stimulus, as they did in 2009 and 2015. The PBOC has cut rates and the government announced that it is bringing forward some fiscal spending. But the priority remains to deleverage and push ahead with structural reform. We do not expect, therefore, to see a significant acceleration of credit growth. Elsewhere in EM, central banks have significantly raised interest rates to defend their currencies, and this is likely to trigger recession in many countries within the next six months. Interest rates: Monetary policy divergences are likely to continue. The Fed will hike by 25 basis points a quarter until there are signs that growth is slowing and that tightness in the labor market is easing. Inflation is not showing signs of dramatic acceleration but, with the labor market so tight, the Fed will want to take out insurance against a future sharp rise. By contrast, the ECB and BOJ have no need to tighten (Chart 15, panel 4). Accordingly, we expect to see US long-term interest rates rise, with the 10-year Treasury bond yield reaching 3.5% in the first half of 2019. Chart 16When Will Earnings Turn Down? Global Equities Stay Cautious: We turned cautious on equities in the previous Quarterly Strategy Outlook,3 by upgrading the low-beta U.S. equity market to overweight at the expense of the high-beta euro area, by taking profit in our pro-cyclical tilt and moving to more defensive sectors, and by maintaining our core position of overweight DM relative to EM. Those moves proved to be effective as DM outperformed EM by 6%, the U.S. outperformed the euro area by 7.5%, and defensives outperformed cyclicals by 1.2%. Because of the sharp underperformance of EM equities relative to DM peers, it's tempting to bottom-fish EM equities. However, we suggest investors refrain from such an urge because we think it's too early to take such risk (see nexts section below). We therefore maintain our defensive tilts in both regional and country allocation and global sector allocation (see table at the end of the report). Equity valuations are less stretched than at the beginning of the year, due to strong earnings growth. However, BCA's global earnings model shows that earnings growth will slow significantly next year (Chart 16, panels 1 & 2). With earnings growth for every sector in positive territory, and the DM profit margin near a historical high, it would not take much for analysts to revise down earnings expectations (bottom 3 panels). Reflecting the GICS sector reclassification, we have initiated a neutral on the Communication sector and an underweight on the Real Estate sector. Chart 17EM Underperformance To Continue Continue To Underweight EM Vs. DM Equities Underweight EM equities vs. the DM counterparts has been a core position in GAA's global equity portfolio (in U.S. dollars and unhedged) this year. Despite the significant performance divergence over the past few months, we recommend investors continue to underweight EM equities, for the following reasons: First, BCA's House View is for the U.S. dollar to strengthen further, especially against EM currencies. This does not bode well for the EM equity performance relative to DM equities, given the close correlation of this with EM currencies (Chart 17, panel 1); Second, Chinese economic growth plays an important role in the EM economy. China's large weight in the EM equity index also makes the link prominent. With increasing concern from the trade war with the U.S., Chinese imports are likely to deteriorate, implying the sell-off in EM shares may have further to go (panel 2); Third, EM earnings growth is closely correlated with money supply as shown in panel 3. Forward earnings growth will have to be revised down given the slowing in money growth. Finally, even though EM equity valuations are now cheap on an absolute basis, EM equities have mostly traded in history at a discount to DM. Currently, the discount is still in line with historical averages (panel 4). Chart 18Real Estate Sector Looks Vulnerable Sector Allocation: Underweight on Real Estate and Neutral on Communication With the recently implemented GICS reclassification, involving the creation of a new Communication Services Sector by moving the media component in Consumer Discretionary and the internet companies in IT to the old Telecom Services sector (see section below for more details), we are reviewing our global sector allocations. Since we were already neutral on IT and Telecom Services, and since the new Communication sector is dominated by internet companies, it's natural to be neutral on the new Communication sector. Real Estate was lifted out of the Financials sector in 2016 to be a separate sector. But we did not include this sector previously in our recommendations because it mostly consists of commercial real estate (CRE) investment trusts. In our alternative asset coverage, we had preferred direct real estate due to its lower correlation with equities in general. In July this year, however, we downgraded exposure to direct real estate.4 It's much easier to reduce REITS holdings than direct CREs. As such, we take this opportunity to initiate an underweight on the Real Estate sector, mainly because of the less favorable conditions in both the macro backdrop and industry fundamentals. From a macro perspective, the tailwind from declining interest rates has turned into a headwind as interest rates rise. Over the past few years, the relative performance of Real Estate to the overall equity index has been closely correlated with the rise and fall of the long-term interest rates. BCA expects 10-year interest rates to trend higher. This does not bode well for the sector's equity performance going forward (Chart 18, panel 1). Industry fundamentals look vulnerable as well. The occupancy rate has already started to decline (panel 2). CRE prices have been making new highs on an inflation-adjusted basis, fueled by a historically high level of CRE loans and low level of loan delinquencies (Chart 18, panels 3 and 4). All these make the CRE sector extremely vulnerable. Government Bonds Maintain Slight Underweight On Duration. The U.S. 10-year government bond yield traded in a tight range in Q3 between 2.8% and 3.1%. With the current yield at 3.07% and the most recent inflation reading below expectations, it's tempting to take a less bearish view on duration, especially given the weakness in EM economies and EM asset prices. We agree that the spillover from weak global growth into the U.S. might cause the Fed to pause its gradual 25bps-per-quarter rate hike cycle at some point in 2019; however, markets currently have priced in only two rate hikes in the entire year of 2019, which means the risk is already priced in. With increasing pressure from rising supply, we still see rates rising over the next 9-12 months and so our short duration recommendation for government bonds is unchanged (Chart 19). Chart 19Rising Supply Will Push Up Rates Chart 20TIPS Breakevens Have A Little Further To Go Favor Linkers Vs. Nominal Bonds. BCA's U.S. Bond Strategy still believes that the U.S. TIPS break-evens will reach to our target range of 2.3%-2.5% because core inflation should remain close to the Fed's 2% target going forward. The latest NFIB survey supports this view as wage pressure is still on the rise, with reports of compensation increases near a record high (Chart 20). Compared to the current breakeven level of 2.1%, this means 10-year TIPS have upside of 20-40bp, an important source of return in the low-return fixed-income space. Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 21Spreads Not Attractive After being overweight for over two years, last quarter we turned neutral on corporates, including high-yield credits, within a global bond portfolio. Developed market corporate bonds have performed poorly in 2018 led by weak returns in the Financials sector and steepening credit curves.5 On the positive side, global corporate health (Chart 21) has been improving, led by the resilience of the U.S. economy and tax cuts that have put corporations in a cyclically healthier position. However, this may not be sustainable as the tightening labor market is pushing up wage growth, which will pressure margins. Interest coverage has fallen in recent years despite strong profitability and low borrowing costs. The risk of downgrades will rise when the earnings outlook weakens or borrowing costs start to rise. An additional concern is that weaker global ex-U.S. growth and a stronger dollar will weigh on U.S. corporate revenues. In the euro area, interest coverage and liquidity continue to improve, supported by easy monetary policies that have lowered borrowing costs. However, with the ECB set to end its corporate bond purchase program along with purchases of sovereign bonds at the end of the year, euro area corporate bonds will lose a major support. In Japan, leverage has been steadily falling and return on capital rising, pushing up the interest coverage multiple to 9.6x, the highest in developed markets. With Japanese corporate profits at an all-time high, default risk is low. The BoJ's forward guidance suggests no tightening until 2020, giving corporates a low cost of borrowing and probably a weak currency. Excess spread from U.S. high-yield bonds after adjusting for expected default losses is 226 bps, slightly below the long-run mean of 247 bps. Most indicators suggest that default losses will remain low for the next 12 months, but it will be critical to track real-time indicators such as job cuts to see if there is any deterioration in growth which might start to push up default rates. With a global corporate bond portfolio, we prefer Japanese and U.S. credits to euro area corporates. Chart 22Prefer Oil Over Metals Commodities Energy (Overweight): Oil prices will continue to be driven by demand/supply fundamentals. We believe that that supply shocks will have more influence on the crude oil price over the coming months than will lower demand from EM (Chart 22, panel 2). U.S. sanctions on Iranian oil exports are estimated to take 800K-1M barrels a day out of global supply. We also factor in the risk of political collapse in Venezuela and outages in Iraqi and Libyan production, which would push oil prices higher. BCA's energy team forecasts that Brent crude will average $80 until year-end, and $95 by the end of the first half of next year.6 Industrial Metals (Neutral): An appreciating dollar along with weaker consumption of base metals in China, the world's largest consumer, are likely to keep industrial metals' prices depressed and to increase volatility over the next few months (panel 3). Additionally, the easing of U.S. sanctions on some Russian oligarchs connected with aluminum producer Rusal is likely to keep a lid on aluminum prices for now. Precious Metals (Neutral): Gold has been weak despite global uncertainties and political tensions arising from the U.S.-China trade spat, Middle East politics, and EM weakness. Since we see further upside in inflation in the coming months and remain concerned about global risk, gold remains an attractive hedge. However, rising real interest rates and the strong dollar will limit the upside (panel 4). Chart 23Further Upside For The Dollar Currencies U.S. Dollar: The dollar has continued its appreciation over the past couple of months, propelled by a moderately hawkish Fed and strong economic data. We see further upside to inflation, though the latest print fell short of expectations. Tighter financial conditions in the U.S. will add further upside to the currency on a broad trade-weighted basis, as well as against other majors (Chart 23, panels 1 and 2). EM Currencies: Dollar appreciation, higher interest rates, increasing trade tensions, and a slowdown in China, have put pressure on EM currencies. We expect these conditions to continue. Sharp interest rate hikes in Argentina and Turkey have not stopped the fall, probably because markets anticipate that the hikes will trigger recessions in these countries. Euro: Weak European economic data and downward growth revisions have put downward pressure on the currency. Additionally, looming political uncertainty in Italy, Europe's large exposure to EM, and continuing trade-war tensions make it likely that the euro will decline further (panel 4). The ECB confirmed its plan to end asset purchases by year-end, but is likely to raise rates only in late 2019. We maintain our view that EUR/USD will weaken to at least 1.12. GBP: Brexit issues continue to affect the pound: the only driver that could push GBP higher would be if both the European Union and the U.K. parliament agree to Theresa May's "Chequers plan". However, with strong opposition from both pro-Brexit Conservative MPs and the Labour Party, the chance of approval seem low. We remain bearish on the pound until there is more clarity on how Brexit will pan out and expect increasing volatility until then. Chart 24Signs Of Overheating In Alts? Alternatives Alternative assets under management continue to grow to record highs, driven by positive sentiment, the global search for yield, and the need for uncorrelated returns. However, there are increasing signs of overheating in the core areas of this market. We analyze our allocation recommendations using a framework of three buckets: 1) return enhancers, 2) inflation hedges, 3) volatility dampeners. Return Enhancers: In H1 2018, private equity (PE) outperformed hedge funds by 6.4% (Chart 24). However, last quarter we recommended investors pare back on their PE allocations and increase hedge funds. Rising competition in PE has pushed deal valuations to new highs, and we expect to see funds raised in 2018-2019 produce poor long-term returns because of higher entry valuations.7 Within the hedge fund space, we recommend investors shift to macro hedge funds, as the end of the business cycle approaches. Inflation Hedges: In H1 2018, commodity futures outperformed direct real estate by over 7%. We remain cautious on commercial real estate (CRE). Loans to CRE have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. As central banks tighten monetary policy, financial stress is likely to appear in CRE. CRE prices peaked in late 2016 and have subsequently moved sideways, partly due to the downturn in shopping malls and retail. Commodity futures, on the other hand, have performed well on the back of rising energy prices. However, we expect increased volatility in commodities due to supply disruptions in oil, and a further slowdown in EM demand. Volatility Dampeners: In H2 2018, farmland and timberland outperformed structured products by 3%. Timberland has a stronger correlation with economic growth via the U.S. housing market. This year, lumber prices have fallen from over $600 to $340, mostly due to speculative action in the futures market. However, this will ultimately impact income from timber sales. Farmland is more insulated from the economy since food demand is autonomous consumption. Structured products face pressures as rising rates push lower-quality tranches closer to default. Investors should favor farmland over timberland, and maintain only a minimum allocation to structured products. Risks To Our View Our main scenario, as outlined in the Overview, is that this year's trends will continue. What might cause them to change? Chart 25China Has Cut Rates A Bit Chart 26...But Fiscal Spending Not Yet Picking Up The biggest risk is Chinese policy. A big stimulus, in line with those in 2009 and 2015, would boost growth in emerging markets, Europe and Japan, push up commodity prices, and weaken the dollar. The PBoC has cut rates (Chart 25) and lowered the reserve requirement. The government has said it will bring this year's budget plans forward, though for now fiscal spending is slowing compared to last year (Chart 26). Faced with a major slowdown and devastating trade war, the Chinese authorities would doubtless throw everything at the problem. But, up until that point, their priority remains deleverage and reform, and so we expect them to do no more than moderately cushion the downside. Chart 27Are Speculators Too Long The Dollar? As always, a major factor is the U.S. dollar, which we expect to appreciate further, as the Fed tightens more than the market expects, and U.S. growth outpaces the rest of the world. What's the most likely reason we're wrong? Probably a situation like 2017, when speculators were very long the dollar just as growth in Europe started to accelerate relative to the U.S. Today, speculative positions are moderately long the dollar, but against the euro and yen not as much as in early 2017 (Chart 27). Aside from a Chinese reflation, it is hard to see what would propel an ex-U.S. growth spurt. True, Japanese capex and wages are showing some signs of life. But Japan worryingly intends to raise VAT in late 2019. And Europe faces considerable political risks - Brexit, Italy, troubled banks, contagion from Turkey - that make it unlikely that confidence will rebound. 1 For more details on this, please see section “What Our Clients Are Asking: Is The Fed Turning Dovish?” in this report. 2 Please see Global Asset Allocation Special Report, "Searching For Yield In A Low Return Environment," dated September 14, 2018 available at gaa.bcaresearch.com 3 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 4 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report titled "A Performance Update On Global Corporate Bond Sectors," dated September 4, 2018 available at gfis.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds of Oil-Price Spike in 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," dated September 20, 2018. 7 Please see Global Asset Allocation Special Report on private equity, "Private Equity: Have We Reached The Top?," dated September 26, 2018 available at gaa.bcaresearch.com GAA Asset Allocation