Developed Countries

Highlights Lingering weakness evident in fundamental supply-demand data will fade next year, and with it the downward pressure on oil prices. Price risk is skewed to the upside: Continued monetary accommodation from systematically important central banks and fiscal stimulus will revive oil demand; OPEC 2.0 production restraint and market-imposed discipline in the US will slow the growth of oil supply. Shale-oil supply growth also is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth. Elevated geopolitical tensions cannot be ignored, particularly as economic and political discontent boils over in Iraq and Iran, where leaders could feel compelled to lash out. To the downside, global economic policy uncertainty remains elevated. It continues to keep the USD well bid. This raises consumers’ local-currency costs in the EM economies driving demand growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Weaker 2019 data showing up in demand and upward revisions to inventories pushed our 4Q19 Brent forecast down to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. We continue to expect WTI will trade $4/bbl below Brent. Feature In the multi-level game that drives the political economy of oil, domestic and international factors shaping supply-demand fundamentals are always shifting. As multiple constituencies vie for advantage, market participants will be forced to grapple with the consequences of policies now under consideration. The bullet points above provide a restricted aperture through which to view some of the issues currently in play.1 Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. Demand-side impacts of policy shifts and policy signaling remain the most prominent feature of fundamental adjustments markets will continue to grapple with, as fall-out from the Sino-US trade war; political discontent in DM and EM electorates; and ad hoc economic policy raise global economic policy uncertainty. Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. This is most visible in our global Leading Economic Indicators (LEIs), particularly in EM economies, although DM demand also looks like it could pick up (Chart of the Week). For the real economy, it is useful to remember Milton Friedman’s “long and variable lags” regarding the effects of monetary policy and how they affect oil markets.2 Chart of the WeekGlobal LEIs Point To Demand Recovery Chart 2BCA's EM Commodity-Demand Nowcast Points Toward Upturn in Oil Demand EM growth is hugely important to global oil-demand growth in our analysis. Our proprietary EM Commodity-Demand Nowcast continues to indicate EM economies are responding to easier global financial conditions (Chart 2).3 Global growth expectations for oil demand are diverging sharply in the lead-up to OPEC 2.0’s December 5 meeting in Vienna. At the low end, the US EIA expects 2019 growth of 760k b/d this year, a sharply lower estimate than the agency’s co-eval institutions; OPEC is closing in on the 1mm b/d growth threshold at 0.98mm b/d, followed by the IEA at 1mm b/d. We lowered our estimate of oil-demand growth this year to 1.1mm b/d, in line with weaker consumption data being reported by these big agencies. Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. We are maintaining our expectation for growth of 1.4mm b/d next year, which is close to the EIA’s estimate (Chart 3). The IEA’s estimate for 2020 stays at 1.2mm b/d, while OPEC’s is just under 1.1mm b/d. On the supply side, we expect lower US shale-oil output growth next year. Lower prices, backwardated WTI futures curves – which results in lower forward prices for producers hedging their output – and recalcitrant investors who are unwilling to commit capital to all but the most profitable shale-oil producers will take their toll (Chart 4). As a result, we expect US shale output to reach ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko). This leads to an 800k b/d increase in our US lower 48 output over this year’s levels, which is down from our earlier estimate of a 900k b/d increase. Chart 3Stronger Oil Demand, Tighter Supply Will Lift Oil Prices in 2020 Chart 4Lower Prices, Backwardated WTI Curve Lead to Lower Rig Count, Shale-Oil Output Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth, as the electorate grows increasingly restive with the practice. Industry officials in Texas and North Dakota – home to the Permian and Bakken plays – already have been sounding the alarm on this issue.4 According to Rystad Energy, flaring reached another record high in the Permian at 752 million cubic feet per day in 3Q19 amid growing oil production. Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest. We also are penciling in an extension of OPEC 2.0’s 1.2mm-barrel-per-day output cut to year-end 2020. Over-compliance likely persists, particularly from the Kingdom of Saudi Arabia (KSA). Stronger non-OPEC output from Norway and Brazil offsets this somewhat (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest.  As our colleague Roukaya Ibrahim notes, “The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services … . This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace.”5 There is an underlying tension within the society between Iraqi forces loyal to Iran’s Shia theocracy and Iraqis seeking full autonomy for their country. “The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary,” according to BCA’s geopolitical strategists. We have consistently maintained markets are too complacent regarding these geopolitical risks, which also encompass US-Iran hostilities in the Persian Gulf. We are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. That said, our balances still reflect the lingering demand weakness discussed above, and continue to work through higher inventories. In line with revisions by the EIA to historical inventory levels and lower demand growth, we are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl (Chart 5). We continue to expect WTI will trade $4/bbl below Brent (Chart 6). Chart 5Storage Revisions Help Weaken Price Forecasts Chart 6BCA 2020 Oil Price Forecasts Fall Slightly To $67/bbl For Brent, $63/bbl For WTI Global Economic Policy Uncertainty Persists While accommodative monetary policy and stimulative fiscal policy will foster a revival in commodity demand, global economic uncertainty remains elevated.6 This risks keeping the broad trade-weighted USD index for goods (TWIBG) well bid (Chart 7). This raises consumers’ local-currency costs in the EM economies driving growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Chart 7Elevated Global Economic Uncertainty Keeps USD Well Bid, Retards Demand We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand.  However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest. As the multi-level game dominating the evolution of the political economy of the oil market becomes more complex and uncertain – particularly in re the Sino-US trade war and domestic politics in systemically important economies – monetary and fiscal policy have an additional headwind to battle in the attempt to revive aggregate commodity demand. Bottom Line: We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand. However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest, with oil prices rising ~ 10% next year. That said, if the phase-one Sino-US trade deal leads to a phase-two and –three – i.e., a durable resolution to the trade imbroglio and political discontent roiling markets, the recovery could be more significant.7     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight. Trade-related news continues to drive short-term price movements. On Tuesday, Brent prices fell 2.5% on rising pessimism about the US-China “phase one” deal. On the supply side, OPEC 2.0 countries will meet in early December to assess whether the group should extend – and possibly deepen – output cuts. Russia signaled it is unlikely to support deeper cuts, but appears to be open to extending the current quotas until year-end 2020. Our updated global oil market balances assume OPEC 2.0 will agree to extend the current production curbs. Separately, anti-government protests in Basra, Iraq, are impacting the oil sector. On Monday, protesters reportedly blocked roads leading to the major oil fields and to commodity export terminals. Base Metals: Neutral. Copper prices seem detached from their current fundamentals, moving up and down with expectations related to the US-China trade war and ongoing protests in Chile – the world’s largest copper producer. Negative sentiment has weighed on copper most of this year. Speculative short positioning reached a high of 137k contracts in August, pushing our Copper Composite Indicator into “oversold” territory. Going forward, the metal’s fundamentals will support higher prices; quarter-to-date copper prices increased 3.5%. Global visible copper inventories resumed their downward trend in 2H19 – reaching a 10-year low. We expect global growth to pick up in the coming months – led by emerging economies. Risks are skewed to the upside. Precious Metals: Neutral. Gold prices recovered to $1475/oz after trading close to our $1450/oz stop-loss last week. Slightly weaker real rates in the US and ratcheted-up trade tensions supported the yellow metal’s price this week. Over the short term, prices could be pushed lower as markets await positive developments re a Sino - US trade agreement. Ags/Softs: Underweight. Corn futures traded lower earlier in the week, but rebounded slightly Tuesday after the USDA Crop Progress reported the harvest rate for it was 76%, which was below analysts’ expectations of 77% and well below the five-year average of 92%. Wheat performed better, marking a 0.9% weekly increase in March futures on the back of a lower percentage of the crop being rated good or excellent by the USDA.  Finally, soybeans were flat throughout the week but fell almost 0.8% on Wednesday, amid reports that a phase-one trade deal between US and China may not be completed by the end of 2019.     Footnotes 1       Understanding and balancing these interests is difficult, as is forecasting outcomes. Please see Robert D. Putnam, “Diplomacy and Domestic Politics: The Logic of Two-Level Games,” International Organization, Vol. 42, No. 3 (Summer, 1988). 2      Friedman’s classic paper, “The Lag in Effect of Monetary Policy,” appeared in the Journal of Political Economy, Vol. 69, No. 5 (Oct., 1961). Our own research suggests these lags range from six to 18 months in commodity markets. 3      Our EM Commodity-Demand Nowcast uses our Global Industrial Activity (GIA) Index, and our Global Commodity Factor (GCF) and EM Import Volume (EMIV) models to characterize the current state of commodity demand. The GIA index uses trade data, FX rates, manufacturing data, and Chinese industrial activity statistics to gauge current global industrial activity, which is highly correlated with trade-related activity. The GCF uses principal component analysis to distill the primary driver of 28 different commodity prices traded globally. Lastly, the EMIV model is driven by EM import volumes, which are highly correlated with income; as income rises, oil demand – and commodity demand in general – rises. Please our report entitled Global Financial Conditions Support Higher Commodity Demand, which was published October 31, 2019, for additional discussion. It is available at ces.bcaresearch.com.  Concerns over associated natural-gas flaring into the atmosphere are rising in the shale-oil community, as political discontent with the practice grows.  Please see Gas Flaring “Running Rampant” In The Permian, published by oilprice.com, and New Initiative will Map and Measure Methane Emissions Across the Permian Basin, a press release issued by the Environmental Defense Fund outlining their initiative to install methane emissions-monitoring gear around the Permian to begin logging the massive amount of flaring in that basin.   According to the Oil & Gas Journal, “… collective volumes of flared and vented gas from (the Permian and Bakken) basins up to about 1.15 bcfd. For comparative purposes, that represents 12 billion cu m/year of wasted gas, which exceeds the yearly gas demand of nations such as Israel, Colombia, and Romania.”  Please see Permian gas flaring, venting reaches record high published by the OGJ June 4, 2019.  Please see Permian gas flaring reaches yet another high, published by Rystad Energy on its website November 5, 2019. 4      S&P Global Platts posted an interesting podcast on its website featuring an interview with Lynn Helms, director of the North Dakota Department of Mineral Resources. He said flaring in the Bakken – where production is hitting record highs – will force state regulators to throttle back on the rate of shale-production growth beginning in 2Q20, when growth could slow substantially if gas-capture technologies are not deployed.  Growth could remain subdued for 2020-21, he said.  Please see North Dakota’s record oil growth to be upended by flaring rules, posted November 18, 2019. 5      Please see Iraq's Challenge To Iran Is Underrated, published by BCA Research’s Geopolitical Strategy November 8, 2019.  It is available at gps.bcaresearch.com. 6      We measure uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related to economic policy uncertainty, which are found in newspapers and articles online from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 7      This is not our base case. Our geopolitical strategists expect a temporary ceasefire in the trade war, but doubt that a “grand compromise” leading to a new period of US-China economic engagement will emerge from the negotiations. Strategic tensions will keep rising on a secular basis between the two countries. Please see BCA’s Geopolitical Strategy weekly report entitled How Much To Buy An American President? – GeoRisk Update: October 25, 2019. It is available at gps.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Underweight Bellwether CSCO’s latest guidance was weak and confirmed that the capex-laden S&P communications equipment tech sub-index is in for a rough ride. Worryingly, CSCO’s key enterprise segment has no pulse. Historically, this data series has been positively correlated with telecom carrier capital outlays and the current message is grim (second panel). Tack on the ongoing manufacturing recession with CEOs canceling/postponing capital spending plans and the outlook dims further for the revenue prospects of communications equipment vendors (third & bottom panels). Adding insult to injury, the US/China trade war is further complicating the picture as the ongoing tariffs have exacerbated the global growth slowdown, and global capex plans have come under intense scrutiny. Bottom Line: Continue to avoid the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV. Please refer to this Monday’s Weekly Report for more details.

Highlights Stock markets are set to produce low single digit returns in 2020. Favour stocks over bonds and cash, especially where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Underweight zero and negative yielding high-quality bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. The biggest risk in 2020 is if the global bond yield were to rise towards 2.5 percent exposing the fragility of risk-asset prices to higher bond yields. The $400 trillion global risk-asset edifice dwarfs the $80 trillion global economy by five to one. Fractal trade: Short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Feature For all the talk of economic growth driving stock markets, the big story through 2018-19 has been bond yields driving stock markets. This is true in Europe as well as more broadly – and it is very easy to demonstrate by decomposing the stock market price into its two components: the underlying profits (earnings per share) and the valuation multiple paid for those profits (Chart of the Week). Chart of the Week2018 And 2019 Were All About Valuations. What About 2020? 2018 And 2019 Were All About Valuations Contrast 2018-19 with 2017. In 2017, the stock market’s stellar return came almost entirely from growth – profits surged while the multiple drifted sideways. But in 2018 and 2019, the story was all about valuation multiples – profits drifted sideways while the multiple plunged in 2018, and then symmetrically surged in 2019 (Chart I-2 and Chart I-3). Chart I-2Decomposing Stock Market Performance... Chart I-3...Into Valuation And Profits The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on bonds drives the prospective return on competing long-duration assets, like equities and real-estate. Higher bond yields require a higher prospective return on equities, meaning a lower valuation multiple, while lower bond yields require a higher valuation multiple. In driving the swing in bond yields, the principal player was the Federal Reserve. Again, this is hardly surprising given that the ECB and BoJ are stuck on the side lines with monetary policy already locked at ‘maximum accommodative’, while the Fed can still move the lever in both directions. The cause of the stock market multiple contraction and re-expansion was the dramatic swing in bond yields. Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.3 percent and then down again to around 2 percent where it stands today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then back up again to 16 where it stands today (Chart I-4). Chart I-4The Round Trip In The T-Bond Yield Explains The Round Trip In The Stock Market's Valuation Admittedly, the Fed’s dramatic pivot was influenced by the trade war, and the perceived threat to global growth. But two other considerations loomed large: the persistent undershoot of inflation versus its 2 percent target; and the fragility of risk-asset valuations – and thereby financial conditions – to higher bond yields. Bear in mind that the value of global risk-assets at over $400 trillion now dwarfs the $80 trillion global economy by a factor of five to one. So the main danger is not that economic imbalances and fragilities will drag down the financial markets; the main danger is that financial market imbalances and fragilities will drag down the economy – as we painfully felt in 2000, 2007, and 2011. The Valuation And Growth Outlook In 2020 The two key investment questions for 2020 are: What will happen to bond yields, and what will happen to stock market profits? Starting with bond yields, most of the major central banks are, to repeat, out of play. Leaving the Fed as the principal player. But at the last press conference, Jay Powell, made it crystal clear that the Fed is also out of play for the time being, at least when it comes to raising rates. “We've just touched 2 percent core inflation, and then we've fallen back. So, I think we would need to see a really significant move up in inflation that's persistent before we even consider raising rates to address inflation concerns.” Reinforcing this, Powell also hinted at introducing a potential ‘tolerance band’ around the 2 percent inflation target – perhaps 1.5-2.5 percent – before the central bank would need to react. “We're also, as part of our review, looking at potential innovations… changes to the framework that would be more supportive of achieving inflation on a symmetric 2 percent basis over time… these changes to monetary policy frameworks don't happen really quickly (but)… I think we'll wrap it up around the middle of next year. I've some confidence in that.” What about profits – could 2020 be a repeat of the 2017 stellar growth story? No, there are two reasons why it will be very difficult to repeat the 2017 story on profits. The two reasons come from the two components of profits: sales and profit margins. Unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up. The first reason is that, unlike in 2017, global sales will not start 2020 at the very depressed levels from which they can play a very strong catch-up (Chart I-5). Significantly, the recession in global sales through 2015-16 was comparable to that suffered in 2008-09. The 2015-16 recession just hasn’t been well documented because it was essentially an emerging markets recession rather than the developed market recession of 2008-09. Chart I-5Global Sales Are Not Depressed The second reason is that today’s profit margins are still close to their structural and cyclical peak; whereas at the start of 2017, they were at a cyclical low (Chart I-6). Chart I-6Profit Margins Are Elevated Hence, the two components of profits – sales and profit margins – will start 2020 at elevated levels. The upshot is that profits can grow in 2020, but the growth will be pedestrian at best. Let’s summarise some of the key investment messages for 2020. High quality bond yields that are near the lower bound of -1 percent cannot go much lower, but those yields in the region of 2 percent cannot go significantly higher. It follows that fixed-income investors should underweight zero and negative yielding bonds versus higher yielding bonds – for example, underweight Swiss bonds versus US T-bonds. In a negative growth shock, T-bonds can still offer substantial capital gains but Swiss bonds cannot. For currencies, it is the opposite message. Favour lower yielding currencies because the central bank loses the ability to depress its own currency. For 2020, our preferred expression of this is long SEK/USD. Stock markets are set to produce low single digit returns. This is uninspiring, but in a world of low prospective returns from all major asset-classes, favour stocks over bonds and cash. This is especially true in those regions and countries where bond yields are zero or negative – specifically, Germany, Switzerland, and Sweden. Today’s profit margins are still close to their structural and cyclical peak The biggest risk to this view is if the global bond yield were to rise towards 2.5 percent exposing the fragility of the risk-asset edifice to higher bond yields. To repeat, the value of global risk-assets, at over $400 trillion, dwarfs the $80 trillion global economy. So the biggest risk comes from the valuation of global financial markets, it does not come from the global economy. More About Price To Sales Having completed our 20 paragraphs on 2020, we would like to follow up on the analysis in last week’s report: Are European Stocks Attractive? To recap, we found that price to sales is the stock market valuation metric that has the best predictive power for prospective returns – because unlike other metrics such as assets, profits, and cash flow, sales are quantifiable, unambiguous, and undistorted by profit margins. In last week’s report our prospective return forecasts were based on price to sales data sourced from Thomson Reuters. To which, several clients asked if the analysis would be the same using the price to sales data sourced from MSCI (Chart I-7). The answer is broadly yes. Chart I-8-Chart I-10 illustrate that: Chart I-7Despite The US, Germany, And Japan Trading On Different Valuations... Chart I-8...The Prospective Return From The US Is Low Single Digit... Chart I-9...The Prospective Return From Germany Is Low Single Digit... Chart I-10...The Prospective Return From Japan Is Low Single Digit... First, despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical. Second, the implied prospective returns from the MSCI calculated price to sales are slightly lower than from the Thomson Reuters data, because current MSCI valuations are closer to the dot com bubble peak. Third, this just reinforces the point that stock market valuations are very fragile to higher bond yields, as already discussed in our preceding 20 paragraphs on 2020. Fractal Trading System* This week we note that the strong outperformance of the Irish stock market is vulnerable to a correction based on its broken 65-day fractal structure. Accordingly, this week’s recommended trade is short Ireland (ISEQ 20) versus Europe (Stoxx Europe 600). Set the profit target and symmetrical stop-loss at 4 percent. In other trades, we are pleased to report that long gold versus nickel achieved its 11 percent profit target and is now closed. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Underweight Similar to utilities, REITs have come to the forefront lately as they have populated the top return sector ranks. Importantly, today several key factors signal that investors should shed public market real estate exposure. Namely, weakening supply/demand dynamics, pricing pressures, macro headwinds and still pricey valuations (primarily rock bottom cap rates) are all firing warning shots. On the demand front, not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble (third & bottom panels). Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (second panel). This tightening backdrop coupled with decelerating credit growth, will continue to weigh on CRE prices and S&P REITs.  Bottom Line: We reiterate our underweight rating in the S&P real estate sector. For more details, please refer to the most recent Weekly Report. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. ​​​​​​​

Share buybacks have been a key pillar underpinning stocks since the GFC averaging roughly $500bn/annum since 2010. But, last year equity retirement jumped to nearly $1tn/annum. That is clearly unsustainable, warning that there is a disconnect between the S&P 500 and already steeply decelerating share buybacks. Our equity retirement estimate for next year is a return to the 10-year average, signaling that the market may hit a significant air pocket (top panel). Further, if margin debt that typically confirms SPX breakouts does not recover soon, it will exert downward pull on the broad market (middle panel).   The S&P 500 earnings growth surprise factor, which is based on sell side analysts’ 12-month forward EPS forecasts, also suggests that 10% profit growth is not plausible for 2020. Bottom Line: Remain cautious on the prospects of the broad equity market. For more details, please refer to the most recent Weekly Report.    

Highlights Global Growth: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. New Zealand: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades. Feature Investors have a lot of information to process at the moment. The daily ebb and flow of headlines on the US-China trade negotiations remains the biggest source of intraday volatility. Yet there are also mixed signals coming from economic data releases. “Soft” survey data like global manufacturing PMIs are showing some improvement, while “hard” measures of economic activity like export volumes and capital goods orders continue to languish in both the developed and emerging economies. As we have discussed in recent reports, these sorts of cross-currents are typical at cyclical inflection points. “Hard” data is reported with a lag after “soft” data, making the latter a better indicator of future economic activity than exports or fixed investment data (or even GDP data) that can be several months old once reported, reducing their market-moving relevance. The indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. When global growth is in the process of bottoming, as appears to be the case now, leading economic indicators are more reliable guides to follow for investment decision-making. To that end, the indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. The Latest From Our Global LEI & Global ZEW Chart of the WeekMore Cyclical Upward Pressure On Bond Yields We received updates on two of our most reliable indicators – our global leading economic indicator (LEI) and the global ZEW expectations index – last week. Both showed broad-based improvement, highlighting that the sharp downward momentum in global growth seen over the past year is in the process of bottoming out. The global LEI and the global ZEW index are key inputs into our Duration Indicator, which has historically led developed market bond yields by between six and nine months (Chart of the Week). The Duration Indicator bottomed back in January of this year and, right on cue, the yield on the Bloomberg Barclays Global Treasury Index has gone up 28bps from the low seen on September 3. The improvement in our global LEI is also broad based. The diffusion index (i.e. the share of countries with a rising LEI) shows that around 75% of the countries in the global LEI are experiencing improved economic activity. Importantly, that share is consistent across both the developed market (DM) and emerging market (EM) nations in the indicator, heralding a synchronized improvement in global growth. (Chart 2).   In absolute level terms, however, the EM sub-component of our global LEI has shown the most dramatic improvement over the past several months, compared to the DM sub-index that is only in the process of bottoming out. The EM index is boosted by improvements in large economies like China and Mexico – countries that have seen significant easing of monetary policy and financial conditions over the past 6-9 months. At the same time, the lagging performance of the DM component of our global LEI is consistent with the more subdued signals to date from the individual DM country data. The US LEI continues to drift lower, while the LEIs within the euro area for Germany, Italy and (most notably) France have all been moving higher (Chart 3). Even the Japan and UK LEIs have picked up a bit, although both remain at only moderate levels. At the same time, the expectations components of the individual country ZEW surveys have all begun to increase (bottom panel), despite more mixed performance within the current conditions components of the same ZEW survey (top panel). Chart 2Our Global LEI Continues to Climb, Led By EM Chart 3A Mixed Bag Of DM Growth Indicators Without a doubt, a reduction of US-China trade tensions would flatter the bullish growth signals seen in the global LEI and ZEW indices. Yet the turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. The turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. Taken together, these signals are all bond-bearish, on the margin. The diffusion index of our global LEI has proven to be an excellent leading indicator of the real component of DM bond yields, leading the latter by around one year, and is pointing to higher yields ahead (Chart 4). At the same time, the inflation expectations component of DM yields (measured using CPI swaps rates) is also expected to drift higher in the next 6-12 months, led by firmer oil prices and some softening of the US dollar. Global central banks will maintain a dovish bias over at least the first half of 2020, to ensure that there is enough positive growth momentum to push inflation expectations back up towards policymaker targets. This means that there can be some modest bear-steepening of government bond yield curves across the major DM nations over the next 6-9 months (Chart 5), as policymakers will not begin to raise policy interest rates too soon. Chart 4Global Yields Moving Higher For The Usual Reasons Chart 5Higher Inflation Expectations = Steeper Yield Curves Chart 6Global Yields Starting To Climb Above Moving Averages The notable exception is the UK. Inflation expectations there are already elevated due to Brexit uncertainty, which has depressed the pound and reduced UK productivity growth while forcing the Bank of England to maintain highly accommodative monetary policy – all factors that should result in higher UK inflation, both realized and expected. Yet even there, the nominal Gilt curve has been bear-steepening of late, alongside the similar trends seen in the other major DM countries like the US and Germany. The move upward in global bond yields suggested by our most reliable leading indicators suggests more of a slow grinding increase in yields (through higher inflation expectations) rather than a rapid acceleration of real rates. The latter would require a shift towards more hawkish central bank monetary policies, which will not happen before there is a sustained pickup in both growth momentum and inflation expectations. The Federal Reserve is the central bank that is likely to lead that transition, but not until late in 2020 and perhaps not until after the November US presidential election. At the country level, the move upward in yields since the early September lows has begun to take out some technical targets (Chart 6). The benchmark 10-year government bond yield is above the 100-day moving average for the major DM countries (the US, Germany, UK, Japan, Canada and Australia). The 200-day moving averages represent the next key resistance level for those markets. The 10-year yield in Japan has already breached that level, perhaps signaling that similar breakouts are on the way in other major markets. Bottom Line: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. Time To (Finally) Take Profits On Our New Zealand Spread Trades We have been structurally positive on New Zealand (NZ) government bonds since mid-2017. This was originally a shorter-term “tactical” view based on expectations that the Reserve Bank of New Zealand (RBNZ) would be forced to keep policy rates steady due to sub-par domestic economic growth and sluggish inflation. Since this was occurring at a time of improving global economic growth in 2017, especially in the US and euro area, we expressed our view as spread trades between 5-year government bonds in NZ versus equivalent maturity debt in the US and Germany (hedged back into US dollars and euros, respectively). The “tactical” trade turned into a medium-term recommendation, as the NZ economy and inflation slowed more than expected. NZ government bonds significantly outperformed global peers as a result, helping boost the returns on our recommended trades. The 5-year NZ-US yield spread has fallen from +74bps when we first initiated the trade to -52bps today, while the spread for 5-year NZ-Germany has narrowed from +292bps to +171bps (Chart 7). We now see several good reasons to take profits on those long-standing positions: NZ economic growth is set to improve The year-over-year growth rate of real GDP in NZ has slowed from 3.1% in mid-2017 (when we initiated our spread trades) to 2.1% in the Q2/2019 (Chart 8). This has occurred in both the manufacturing and services sides of the economy, based on the sharp drop in the PMIs (middle panel). Export growth has also slowed, particularly during the recent global manufacturing downturn, leading to sharp declines in business confidence and capital spending plans. The economic weakness was enough to push NZ real GDP growth below the rate of potential GDP - which is estimated by the RBNZ to have fallen from 3% to 2.5% due primarily to slowing population growth related to reduced net immigration into the country. Chart 7NZ Bonds Have Solidly Outperformed Chart 8NZ Growth Should Soon Bottom Out The long slump in NZ manufacturing appears to have ended, however. The manufacturing PMI index jumped 3.8 points to 52.6 in October, with the New Orders component rising 5.3 points to 56.2. This pushed the New Orders-to-Inventories ratio – a leading indicator of overall NZ business sentiment – to the highest level since March 2017 (bottom panel). The domestic side of the NZ economy is also set to improve (Chart 9). Consumer spending has been weighed down by both the structural factor of slowing immigration and the cyclical factor of slowing house prices. Median NZ house price growth has perked up of late, however, in response to the RBNZ’s rate cuts this year, which should help boost consumer spending through wealth effects. Business investment should also start to speed up as manufacturing activity improves, especially with the terms of trade (relative prices of NZ exports to imports) now starting to accelerate (middle panel). The external side of the economy is also set for some improvement. In the November 2019 RBNZ Monetary Policy Statement (MPS) published last week, the central bank laid out a very cautious forecast for an increase in the GDP growth of NZ’s trading partners in 2020 (bottom panel). The sharp pickup in the EM component of our global LEI, however, suggests that global growth, and demand for NZ exports, may be much stronger than the central bank envisions next year. NZ’s economy is running at close to full capacity In the November MPS, the RBNZ also presented its own estimates for spare capacity in the NZ economy, using a variety of economic models for both the output gap and the full employment “NAIRU” (Chart 10). The median estimate of the output gap models is around 0% and is expected to stay around those levels for the next two years. The NZ unemployment rate is projected to be stable around 4% through 2020, which is close to the median model estimate of NAIRU. Thus, by the central bank’s own reckoning, the NZ economy is running at full capacity. Chart 9An Upside Growth Surprise In 2020? Chart 10NZ Does Not Need More Rate Cuts The RBNZ also produces model estimates of the neutral level of its policy rate, the Overnight Cash Rate (OCR). The current OCR of 1.0% is at the low end of the range of model estimates (bottom panel). This seems inconsistent with an economy that may be operating with no spare capacity, as the RBNZ’s other models suggest. Those models appear to be giving an accurate read on the inflationary tendencies of the NZ economy, though. Underlying NZ inflation is accelerating While headline CPI inflation fell to 1.5% in Q3/2019, close to the bottom of the RBNZ’s 1-3% target band, core CPI inflation accelerated to 1.9% - just below the midpoint of the band (Chart 11). The decline in headline inflation can be attributed to weakness in the tradeables component of the CPI, but this should soon start to increase based on the lagged impact of the acceleration of energy prices denominated in NZ dollars (middle panel). With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. Meanwhile, non-tradeables (i.e. domestically generated) CPI inflation has accelerated over the past few quarters and is now at 3.2% - above the top end of the RBNZ inflation band. This has occurred alongside an acceleration of average hourly earnings growth to 4.2%, suggesting a tight labor market that confirms the message from the RBNZ’s NAIRU models. NZ monetary conditions are now very easy With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. The central bank also produces estimates of the neutral real rate in NZ, using the same “r*” framework used by the US Federal Reserve (Chart 12). The neutral real rate is estimated to be 1.25% which, when added to the 2% midpoint of the RBNZ’s target band, produces a neutral nominal rate of 3.25% - a whopping 225bps above the current OCR rate. Chart 11NZ Inflation Bottoming Out Chart 12NZ Monetary Conditions Now Appear Too Easy With rates so far below neutral in nominal terms, it is no surprise that the NZ dollar is at such low levels versus both the US dollar and the euro (bottom panel). This is providing an additional easing of monetary conditions that will help boost NZ growth and inflation over at least the next year – and likely force the RBNZ to stop cutting rates and, perhaps, even begin to lay the groundwork for taking back some of the 2019 rate reductions. In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit. NZ yields look too low versus the US and Germany Our fair value regression models for both the 5-year NZ-US spread (Chart 13), and the 5-year NZ-Germany spread (Chart 14), are both signaling that NZ government bonds are relatively expensive. These models estimate the fair value of the spreads as a function of relative central bank policy rates, relative unemployment rates and relative inflation rates. Both models suggest that the cross-country yield spreads have tightened too much relative to the economic fundamentals of NZ, the US and Germany. Chart 13NZ Government Bonds Look Expensive Versus US Treasuries ... Chart 14... And German Government Debt In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit (see the Tactical Overlay Trade table on Page 16). Bottom Line: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns