Economy

Highlights Earnings season concerns will not materialize, … : The energy sector is suffering, but overall third-quarter S&P 500 earnings are comfortably beating consensus expectations and the bears’ worst-case-scenario handwringing.  … but there are other snares that could trip up the economy: Business and consumer pessimism can become self-fulfilling, and a material worsening in U.S.-China relations could trigger a fresh wave of gloom. We examined past bull-market cycles for a sense of the rally’s vulnerability: Cycle-on-cycle analysis of economic activity, inflation pressures, earnings expectations and investor sentiment does not suggest that the end of the bull market is yet in sight. Feature Chart 1Just Enough Earnings Growth For A New High Earnings season will not short-circuit the equity rally. Nearly three-quarters of S&P 500 constituents have reported their third-quarter results, and while Friday’s releases from the oil majors erased modest year-over-year growth in index earnings per share, earnings have beaten expectations by 3 to 4%. That’s not much to write home about in an absolute sense, but financial assets are graded on a curve, and earnings are poised to beat projections of a 2-4% year-over-year decline for the third consecutive quarter. Flat-to-slightly-higher earnings (Chart 1, second panel), combined with two-plus points of multiple expansion since the beginning of the year (Chart 1, bottom panel), have allowed the S&P 500 to gain 20% year to date (Chart 1, top panel), recouping the ground lost in last year’s fourth-quarter swoon and powering the index to new all-time highs. Stocks are not cheap, but we find that valuation only matters at extremes. At about three-quarters of a standard deviation above the mean, the S&P 500 is hardly trading at an extreme valuation (Chart 2). As Chart 1 showed, the large-cap benchmark is simply back to the 17 multiple that has been its mean valuation over the last three years. Investors are not euphoric, and the S&P 500 is therefore not in danger of a sudden de-rating. Chart 2Stocks Aren't Cheap, But Valuation Is Not A Pressing Concern Very slightly higher earnings and a restored multiple explain how stocks have surpassed their previous high, but where do they go from here? The bull market may be long in the tooth, but it can continue as long as the conditions supporting its rise to date remain in place. Monetary policy is easy, there is no recession in sight, and global growth is poised to revive. If the U.S. and China can reach enough of a détente to prevent a recession-inducing free fall in business and/or consumer confidence, equities should resume bounding up the wall of worry. Equity bull markets explode out of the gate and sprint to the finish, with a lot of trotting and grazing in between. Our view isn’t new, however, and an earnings stumble was not a major consensus concern. U.S.-China relations appear to be moving in the right direction, but our Geopolitical Strategy team has repeatedly cautioned against expecting a quick or clear solution to the trade component of what projects to be a lengthy struggle for hegemony between the established economic superpower and the new kid on the block. For new insight into the remaining duration of the equity bull market, we examined the contours of past cycles. We compared today’s economic and market conditions to the conditions that have commonly prevailed in the waning days of the six complete S&P 500 bull markets of the last 50-plus years. On balance, it does not appear that the current bull market is nearing its expiration date. Ground Rules We define a bull market as a 20% trough-to-peak gain in S&P 500 closing prices, and a bear market as a 20% peak-to-trough closing-price decline. Since 1966, there have been seven bear markets, six completed bull markets, and the current bull market that is now over ten-and-a-half years old (Table 1). We have slightly tweaked our definitions from prior analyses, leaving out the S&P 500’s 19.9% peak-to-trough decline from July to October 1990, and excluding the 21% gain from late September 2001 to the beginning of January 2002, which was more of a dead-cat bounce than a true bull market. The completed bull markets in our sample span 8,400 trading days, or the equivalent of over 33 market years. Table 1Bear And Bull Markets, 1966-2019 Bull Markets End In Stampedes We have noted before that bull markets tend to sprint to the finish line. The six completed bull markets from 1966 have exhibited a pronounced pattern in which they only materially exceed their overall pace of gains in their first and last deciles (Chart 3). The first-decile performance is easy to explain: bull markets begin in despair, when investors largely lament their equity holdings, and have little interest in adding to them. Falling earnings expectations and low P/E multiples push stocks down, but set the stage for a rapid move higher once sellers become exhausted. Chart 3Bull Markets Sprint To The Finish Line Chart 4Could This Bull Have Ended So Quietly?   The last decile’s surge seems to be the mirror image, powered by professional investors who’ve failed to participate in at least the latter stages of the advance and capitulate under the pressure of relative underperformance. They are joined by individuals who have turned green with envy at their co-workers’ and neighbors’ lusty tales of market conquest and jump into the market in an attempt to capture their share of the bounty. The buying pressure they produce is often accompanied by earnings expectations that extrapolate a favorable fundamental backdrop well into the future. The bull market ends when there are no more marginal buyers left to maintain the upward impulse, just as bear markets end when there are no more sellers to sustain downward pressure. The real economy is not running hot the way it typically does at the end of the cycle. If the bull market ended last Wednesday, when the S&P 500 made its record closing high of 3,046.77,1 this bull market will have quietly expired after thirteen months of bumping around a tight range (Chart 4). Bull markets typically burn out, rather than fade away, and it would be unusual if the current bull were to finish without a bang, while its failure to better its overall return in its last decile would be unprecedented (Chart 5). We project that the next recession will not begin until the second half of 2021 at the earliest, which would suggest the bull market will extend at least until the end of 2020. If the bull market were to last that long, the last year-plus of range-bound moseying would shift from the tenth to the ninth decile (Chart 6), preparing the ground for a characteristic closing surge. Chart 5Individual Bull Market Returns By Decile Chart 6A More Familiar Pattern (If The Bull Lasts Through 2020) Bottom Line: Ever since the mid-‘60s, the pace of returns has quickened in bull markets’ final stages. It would be unprecedented if the current bull market were to quietly peter out. Goldilocks Trumps John Henry Bull markets, like economic expansions, end once they can no longer be sustained. When investors begin to extrapolate that feverish activity will continue well into the future, stocks and the economy are primed for disappointment. The cycle analysis of real activity suggests that bull markets don’t typically meet their demise when the real economy is pushed to its maximum speed, but rather when it’s been operated at a level above the speed limit for an extended period. Historically, real GDP has swiftly accelerated after briefly contracting, cooled off over an extended period, and then powered to a new cycle high, from which it only slowly and slightly tapered off as the end of the bull market approached (Chart 7, top panel). Consumer spending has followed the same basic pattern (Chart 7, middle panel), accompanied by elevated and rising credit growth (Chart 7, bottom panel). Consumer spending is well below the average pace of past bull markets, as is credit growth, which has been roughly flat at a moderate pace for four years, falling well below the average bull market pace. The Fed isn't about to get in the economy's way any time soon. Capacity utilization has spent much of past bull markets at or above 80%, but has yet to approach that level in this cycle (Chart 8, top panel). The manufacturing inventory-to-sales ratio has similarly lagged the average level of past bull markets (Chart 8, middle panel), and elevated inventories do not appear to be a source of vulnerability. Housing is one of the most cyclical elements of the economy, and with housing starts lagging household formations, it is not at all overheated relative to past bull market cycles (Chart 8, bottom panel). Chart 7No Overheating In Real Activity (I) Chart 8No Overheating In Real Activity (II)   Chart 9The Fed Will Lay Off Despite A Positive Output Gap Pressures that knock the economy off course aren’t entirely endogenous; inflation concerns can provoke the Fed to make a deliberate attempt to cool activity. Inflation is well below the average of past bull cycles (Chart 9, top panel), and the fact that it has not yet gotten enough traction to be threatening, here or abroad, would seem likely to keep the Fed from hiking rates until well into next year at the earliest. It takes a positive output gap (output exceeds capacity) to promote inflation pressures. Though the IMF estimates that the U.S. output gap has been positive for the last three years (Chart 9, middle panel), persistently soft inflation expectations will likely allow it to remain positive for longer without causing a problem. Real yields are also well below the level that has typically been associated with expiring bull markets (Chart 9, bottom panel). Bottom Line: Cyclical segments of the real economy do not show signs of overheating on their own, and low inflation will keep the Fed from stymying growth with tighter monetary policy until at least the second half of next year. Expectations Matter As we mentioned above, overly optimistic expectations can trip up a bull market. If the earnings bar is set too high, companies have an elevated probability of failing to reach it. P/E multiples are a mean-reverting series, and overly ambitious valuations make stocks vulnerable to an inevitable de-rating. Sentiment is also mean-reverting, and surveys shedding light on investors’ aggregate bullishness or bearishness are classic contrarian indicators. Chart 10Expectations Are Undemanding, But Multiples Are Elevated Earnings expectations have oscillated across the three bull market cycles for which they’ve been compiled, but have risen to double-digit levels at past S&P 500 peaks (Chart 10, top panel). After the immediate aftermath of the crisis, expectations in the current bull market have been muted relative to history, but multiples have been steadily rising over the last five years (Chart 10, bottom panel). Some of the multiple-related concern is relieved by our composite sentiment survey, which is as close to the bottom of its historical range as it has been to the top of the range at the onset of the previous two market peaks (Chart 11, bottom panel). Multiples are the only series in our review that is approaching a danger zone, and we will keep an eye on them.   Chart 11... But Sentiment Is Not Soft Sentiment Is A Tailwind For Stocks Investment Implications Sentiment is a classic contrarian indicator. We took some comfort last week in Barron’s downbeat semi-annual Big Money poll, which jibes with the wariness we’ve sensed in the institutional investors we’ve met. There are credible reasons for concern, and while our base-case scenario is market friendly, this is not a time to load up on risk exposures. Until the skeptical show-me climate eases, big bets could be buffeted by volatility that may undermine an investor’s ability to maintain them. Volatility spikes will occur in spite of the Goldilocks economy. The October employment report showed that she is still alive and well. On the verge of a too-cold reading – the consensus expected a three-month moving average of 130,000 net payroll additions – a hearty October beat, along with significant upward revisions to August and September, produced a 176,000 three-month moving average, smack dab in just-right territory. In our base-case macro scenario, the economy will continue to produce trend growth, helped along by the lagged effect of easier monetary policy in the U.S. and much of the rest of the world. S&P 500 earnings will get a boost from a global ex-U.S. growth revival and the dollar softness that will accompany it. Credit performance will continue to be very good as investor constituencies needing yield, and other parties pressured by FOMO (fear of missing out), keep capital flowing into spread product. The equity bull market will remain intact, and investors should stay the risk-friendly course.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 As we were going to press on Friday, it appeared that a new high would be set around 3,060.

Special Report

In lieu of our regular weekly report, we are sending you a special report by our colleagues Bob Ryan, Chief Commodity and Energy Strategist, and Hugo Bélanger, Senior Analyst, from BCA Research Commodity & Energy Strategy. The report highlights how global economic policy uncertainty over the past year has enabled gold and the USD unusually to rise together. In the near term, the combination of global economic stimulus and a US-China trade ceasefire should reduce policy uncertainty and encourage global demand for commodities. On a cyclical basis this should allow the dollar to fall back, inflation expectations to revive, and gold to appreciate. We trust you will find this research useful and insightful. All very best, Matt Gertken Geopolitical Strategy Feature The once-reliable negative correlation between gold and the USD was indefinitely suspended beginning in 4Q18 by the pervasive economic uncertainty we identified last week as the culprit holding back global oil demand growth via a super-charged dollar.1 This uncertainty is most pronounced in the US and Europe vis-à-vis gold, and partly explains the performance of safe havens, particularly the USD, which has soared to new heights on a trade-weighted goods basis, and gold (Chart of the Week). So far, gold has held its ground after breaking above $1,500/oz from the low $1,200s in mid-2018, indicating investors are much more concerned about economic risks arising from economic policy uncertainty than inflation and other diversifiable risks gold typically hedges (Chart 2). Cyclically we remain positive on gold prices on the back of a lower dollar and rising inflation pressure in the US. Chart of the WeekDemand For Safe Havens Soars As Economic Policy Uncertainty Rises Economic policy uncertainty in Europe and the US supports gold prices. Chart 2AUS, Euro Economic Uncertainty Correlated With Gold Prices Chart 2BUS, Euro Economic Uncertainty Correlated With Gold Prices Even so, we are putting a $1,450/oz stop-loss on our long gold portfolio hedge to cover tactical risks showing up in our technical indicators. In addition, as is the case with oil demand, if the ceasefire we are expecting in the Sino-US trade war materializes in 1H20 and limited trade – mostly in ags and energy – is forthcoming, demand for safe-haven assets could weaken gold prices at the margin. Fiscal and monetary stimulus globally also could revive economic growth and commodity demand, pushing global yields higher, which would put negative pressure on gold at the margin, as well, given the high correlation between real rates and gold prices. Feature The once-reliable negative correlation between gold and the USD will remain muted over the short-term tactical horizon – 3 to 6 months – as economic policy uncertainty continues to stoke global demand for safe havens.2 This can be seen in the elevated correlations between the USD’s broad trade-weighted goods index with the Baker-Bloom-Davis (BBD) Economic Policy Uncertainty (EPU) indexes for the US and Europe (Chart 3).3 Rising economic uncertainty – particularly since 4Q18 – has created a rare environment in which both the USD and gold trended up simultaneously and continue to move in the same direction. The implication of this is that gold’s correlation with both the USD and EPU is weaker than before because economic policy uncertainty now is positively correlated with the dollar. Chart 3Strong USD, EPU Correlation Chart 4Correlation of Daily Gold, USD Returns Also Moving Sharply Higher   There is a possibility global policy uncertainty could be reduced later this year if the US and China can agree on a trade ceasefire... The typically negative correlation between daily returns of gold and the USD also is weakening, moving toward positive territory (Chart 4), as both the USD and gold trend higher simultaneously (Chart 5). Chart 5Gold and USD Levels Trending Higher ...If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. Our short-term technical indicator is signaling an overbought gold market (Chart 6), and our fair-value model indicates gold should be trading ~ $1,450/oz (Chart 7). The latter signal off our fair-value model is less concerning, given the demand for safe-haven assets like the USD and gold now dominates gold’s typical drivers. Chart 6Gold Technical Indicators Signal Overbought Market Chart 7High USD Correlation Throws Off Fair-Value Model However, to be on the safe side, we are placing a $1,450/oz stop-loss on our long-term gold position, which as of Tuesday’s close was up 21% since inception on May 14, 2017. This is a precautionary measure, which recognizes the possibility global policy uncertainty could be reduced later this year if the US and China can agree on a trade ceasefire, and global fiscal and monetary policy are successful in reviving EM income growth, which would revive commodity demand generally, pushing up global bond yields. If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. During that period, the monetary and fiscal aggregates we track as explanatory variables for gold prices will reassert themselves as the dominant drivers of gold prices (see below). This could produce tension between a falling USD and rising real rates as growth picks up, which would send us to a risk-neutral setting re gold, given the current high correlation between gold and real rates, which should remain strong until the Fed starts hiking rates again, most likely in 2020 (Chart 8). This is part of the reason we are including the stop-loss at $1,450/oz for our existing gold position: During this risky period going into 1H20 economic uncertainty could dissipate, and real rates could rise. Although the USD depreciation would mute these effects, rising real rates would be a risk to gold prices. Chart 8Rising Real Rates Could Weaken Gold Prices Economic Uncertainty Dominates Gold’s Fundamentals At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. In Table 1, we collect the variables we consider when assessing gold’s fair value. At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. This variable broadly falls in the geopolitical risk we regularly account for in our analysis of gold markets. Table 1Fundamental And Technical Gold-Price Drivers If the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Checking off each of these groups, we see: · Demand for inflation hedges remaining muted over the short-term, as inflationary pressures remain weak. In line with our House view, however, we do expect inflation could move higher toward the end of next year and overshoot the Fed’s 2% target for the US. This would support gold prices. · Monetary and financial aggregates are working less well as explanatory variables for gold prices in a market dominated by economic policy uncertainty. The USD-gold correlation continues to be disrupted by strong demand for safe-haven assets. As inflation picks up next year, we expect nominal bond yields to rise. Real rates, however, could remain subdued, as long as the Fed is not aggressively raising rates to get out ahead of a possible revival of inflation (Chart 9). Later in 2020, the correlation between rates and gold should be supportive for gold prices – the correlation fades when the Fed tightens, which creates a demand for safe-haven assets like gold. All the same, an increase in real rates would be a risk to gold prices in 1H20. · At present, demand for portfolio-diversification assets via safe-haven assets is a powerful force in gold’s price evolution. It is worthwhile pointing out, however, that if global economic uncertainty is resolved and global growth does rebound, recession fears will diminish, thus reducing the marginal impact of geopolitical shocks. On the other hand, if the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Should that happen, short-term volatility in gold will rise (Chart 10). Chart 9Bond Yields Should Rise As Inflation Revives In 2H20 Chart 10Investors Expect Large Positive Moves In Gold And Silver Prices Investment Implications Over a tactical horizon – i.e., 3 to 6 months – we expect global economic policy uncertainty to remain elevated. Going into 2020 – and particularly in 2H20 – we expect the USD to weaken on the back of global monetary accommodation policies and increased fiscal stimulus. We also are expecting a ceasefire in the Sino-US trade war, which will revive trade somewhat and support EM income growth and commodity demand. These assumptions, which we’ve laid out in previous research, will be bullish cyclical factors supporting commodities generally. Bottom Line: A ceasefire in the Sino-US trade war, coupled with global fiscal and monetary stimulus, will reduce some of the economic uncertainty dogging aggregate demand. This should be apparent in the data in 1H20. As a result, we continue to expect rising EM income growth to be cyclically bullish for commodities generally. This will allow inflation to revive – again, assuming the Fed does not become aggressive in raising rates. Net, this will be bullish for gold: As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries (Chart 11) Chart 11EM Income Growth Will Support Demand For Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1               Please see “Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth,” published October 17, 2019, available at ces.bcaresearch.com. 2              We expect a ceasefire in the Sino-US trade war to be announced in 1H20, which will defuse – but not eliminate – an important risk for global growth in our analytical framework.  We expect this will allow the relationship between the USD and gold to move back to its previous equilibrium in 1Q20 or 2Q20. 3              For more info on the Baker-Bloom-Davis index, please see policyuncertainty.com

Highlights An expansion in the Federal Reserve’s balance sheet will increase dollar liquidity. This should be negative for the greenback, barring a recession over the next six to 12 months. Interest rate differentials have largely moved against the dollar. The biggest divergences are versus the more export-dependent NOK, SEK and GBP. A weak dollar will supercharge the gold uptrend. Gold will also benefit from abundant liquidity, and persistently low/negative real rates. Remain short USD/JPY. The path to a lower yen is via an overshoot, as the BoJ will need a shock to act more aggressively. The Bank of Canada left rates on hold, but may be hard-pressed to continue meeting its inflation mandate amid a widening output gap. Go long AUD/CAD for a trade. Feature Chart I-1A Well-Defined Channel The DXY index has been trading within a very narrow band this year, defined by the upward-sloped channel drawn from the February lows (Chart I-1). At 97, the DXY index is just a few ticks away from the lower bound of this channel, which could be tested in the coming weeks. A decisive break below will represent an important fundamental shift, since it will declare the winner in the ongoing battle between deteriorating global growth and easing financial conditions. Global Growth And The Dollar One of the defining features of the currency landscape last year was that U.S. interest rates became too tight relative to underlying conditions. This tightened dollar liquidity both domestically and abroad. Chart I-2 plots the neutral rate of interest in the U.S. relative to the fed funds target rate. A widening gap suggests underlying financing conditions are low relative to the potential growth rate of the economy. Not surprisingly, this also tends to track the yield curve pretty closely, assuming long-term rates are a proxy for the economy’s structural growth rate, while short-term rates reflect borrowing costs. For economic agents, a narrowing spread suggests a rising risk of capital misallocation, as the gap between the cost of capital and return on capital closes. This is most evident for banks through their net interest margins. At the epicenter of this shrinking spread are the Fed’s macroeconomic policies. These include raising interest rates (especially in the face of a trade slowdown) and/or shrinking its balance sheet. These are the very policies that also tend to strengthen the greenback. The result is a rise in the velocity of international U.S. dollars, pushing up offshore rates and lifting the cost of capital for borrowing countries. A widening gap between U.S. neutral rate of interest and fed funds target rate suggests underlying financing conditions are low relative to the potential growth rate of the economy.  This has been the backdrop for the dollar for much of the past two years. The good news is that more recently, the Fed has been quick to rectify the situation. The funding crisis among U.S. domestic banks will be resolved through repurchase agreements and a resumption of the Fed's bond purchases. Chart I-3 shows that the interest rate the Fed pays on excess reserves may soon exceed the effective fed funds rate, meaning the liquidity crisis among U.S. banks may soon be over. Correspondingly, banks’ excess reserves should start rising anew. The drop in rates and the easing in funding conditions have been partly sniffed out by a steepening yield curve (Chart I-3, bottom panel). This will incentivize banks to lend, which in turn, will boost U.S. money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, this will widen the current account deficit and increase the international supply of dollars. This should further calm dollar offshore rates, helping short-circuit any negative feedback loops that might have hampered growth in the past. Chart I-2The Fed Has Pivoted Chart I-3Easing Liquidity Strains The message from both global fixed-income markets and international stocks is that we may have reached a tipping point, where easing in financial conditions is sufficient to end the manufacturing recession. This is especially the case given this week’s breakout in the S&P 500, the Swedish OMX, and the Swiss Market Index (Chart I-4) – indices with large international exposure and very much tied to the global cycle. Such market cycles also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the U.S. (Chart I-5). Chart I-4A Few Equity Breakouts Chart I-5Europe And EM Leading The Rally Chart I-6Less Stress In Offshore USD Funding Bottom Line: Rising dollar liquidity appears to have started greasing the international financial supply chain. One way to track if dollar funding is becoming more abundant is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury bond and a synthetic one trading in the offshore market. On this basis, we are well below the panic levels observed over the past decade (Chart I-6). Interest Rate Differentials And International Flows If the rise in global bond yields reflects a nascent pickup in growth, then the message from interest rate differentials has been clear: This growth pickup will be led by non-U.S. markets, similar to the message from international equities. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the U.S. (Chart I-7A and Chart I-7B). For example, yields in Norway, Sweden, Switzerland and Japan have risen by an average of 75 basis points versus those in the U.S. since the bottom. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. Chart I-7AInterest Differentials And Exchange Rates Chart I-7BInterest Differentials And Exchange Rates International investors might still find U.S. bond markets attractive in an absolute sense, but the currency risk is just too big a potential blindside at the current juncture. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even the European periphery within Europe might be better bets. Flow data highlights just how precarious being long U.S. dollars is. As of last August, overall flows into the U.S. Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive at an annualized US$166 billion, but the momentum of these flows is clearly rolling over. This is more than offset by official net outflows that are running at $314 billion (Chart I-8). As interest rate differentials have started moving against the U.S., so has foreign investor appetite for Treasury bonds. More importantly, private purchases have not been driven on a net basis by foreign entities, but by U.S. domestic concerns repatriating capital on the back of the 2017 Trump tax cuts. On a rolling 12-month basis, the U.S. was repatriating back close to net $US400 billion in assets, or about 2% of GDP. Given that the tax break was a one-off, flows have since started to ease, contributing to the ebb in Treasury purchases (Chart I-9). Chart I-8A Growing Dearth Of Treasury Buyers Chart I-9Repatriation Flows Are Ebbing Meanwhile, while U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. equity markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners earlier this year, the largest on record. Foreigners are still net buyers of about $265 billion in U.S. securities (mostly agency bonds), but the downtrend in purchases in recent years is evident. Bottom Line: Flows into U.S. assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in comparison to history. Given that being long Treasurys and the dollar remains a consensus trade (Chart I-10), international investors run the risk of a potential blindside from a sharp drop in the dollar. Chart I-10Unfavorable Dollar Technicals Dollar Reserve Status And Gold The decline in the dollar may not mark the ultimate peak in the bull market that began in 2011, but at least it will unveil some of the underlying forces that have been chipping away at the dollar’s reserve status over the past few years. China has risen within the ranks to become the number one contributor to the U.S. trade deficit over the past few years. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB. In a broader sense, there has been an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given that a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities. With the Fed about to embark on a renewed expansion of its balance sheet, we may have just triggered one of the necessary catalysts for a selloff in the U.S. dollar. This means that holding gold in dollars may become more profitable compared to other currencies (Chart I-11). Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of a potential blindside from a sharp drop in the dollar.  The one tectonic shift that has happened over the past decade is that central banks have become net gold buyers, holding 20% of all gold that has ever been mined. If that number were to rise to say 25% or even 30%, it could have the potential to propel the gold price up towards $2800/oz (Chart I-12). If you think such an idea is far-fetched, just ask the Swiss, who a few years ago called a referendum to increase their gold holdings from 7% of total reserves to 20%, or Russia that has seen its gold holdings rise from 2% to over 20% of total reserves. Chart I-11Watch Gold In ##br##USD Terms Chart I-12What If Central Banks Bought Gold More Aggressively?   Bottom Line: Reserve diversification out of U.S. dollars is a trend that has been underway for a while now, and unlikely to change anytime soon. Gold will be a big beneficiary of this tectonic shift. A Few Trade Ideas If the dollar eventually weakens, the more export-dependent economies should benefit the most from a rebound in global growth, and by extension their currencies should be the outperformers. Within the G-10 universe, there would notably be the European currencies led by the Swedish krona, the Norwegian krone and the pound. The countries currently experiencing the steepest rise in interest rate differentials vis-à-vis the U.S. could be a prelude to which currencies will outperform (previously mentioned Chart I-7A). We expect commodity currencies to also hold firm, but this awaits further confirmation of more pronounced Chinese stimulus, which so far has not yet materialized. The Canadian dollar should also be a beneficiary from dollar weakness, with a technical formation that looks categorically bearish USD/CAD (Chart I-13). Should the 1.30 level be breached, the next level of support is around the 2017 lows of 1.20. The BoC left rates unchanged this week, but the dovish tone from Governor Stephen Poloz was a big reminder that no central bank wants to tolerate a more expensive currency for now. Looser fiscal policy and rising oil prices will eventually become growth tailwinds. Chart I-13A USD/CAD Breakout Or Breakdown? Chart I-14Canadian House Prices However, we will favor the Aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. And with macro-prudential measures already implemented in Vancouver and Toronto, there is a rising risk that Montreal could follow suit (Chart I-14). Historically, policy divergences between the Reserve Bank of Australia and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-15). Go long AUD/CAD for a trade. Chart I-15Buy AUD/CAD Finally, the Bank Of Japan left interest rates unchanged but signaled it was willing to ease should the path towards their 2% inflation target be in question. As the central bank that has been pursuing the most aggressive monetary stimulus over the last few years, it is fair to say this week’s policy meeting was a non-event. The yen will continue to be buffeted by powerful deflationary tailwinds that are holding the Japanese economy hostage, as well as global economic uncertainty. In the event that global growth picks up, the yen will depreciate at the crosses, but can still rise versus the dollar. This puts long yen bets in a “heads I win, tails I don’t lose much” scenario. Bottom Line: Go long AUD/CAD and stay short USD/JPY. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Preliminary GDP growth slowed to 1.9% quarter-on-quarter from 2% in Q3. PCE slowed to 1.5% quarter-on-quarter in Q3. Core PCE, on the other hand, increased to 2.2%. New home sales contracted by 0.7% month-on-month in September, while pending home sales grew by 1.5% month-on-month. The trade deficit narrowed marginally by $2.7 billion to $70.4 billion in September. Initial jobless claims increased by 5K to 218K for the week ended October 25th. The DXY index fell sharply after the Fed's press conference, ending with a loss of 0.6% this week. On Wednesday, the Fed cut interest rate by 25 bps for the third time this year to 1.75%, as widely expected. The fading interest rate differential will continue to be a headwind for the U.S. dollar. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been firm: GDP growth in the euro area slowed marginally to 1.1% year-on-year in Q3, down from 1.2% in the previous quarter. On a quarter-on-quarter basis, the growth was unchanged at 0.2%. Headline inflation in the euro area slowed slightly to 0.7% year-on-year in October. Core inflation however, increased to 1.1% year-on-year. Retail sales in Germany grew by 3.4% year-on-year in September, up from 3.1% in the previous month. EUR/USD increased by 0.5% this week amid broad dollar weakness. The current debate among central bankers in the Eurozone is whether ultra accommodative monetary policy is still warranted. This espouses the view that at least, to some members of the ECB, the neutral rate of interest in the Eurozone is higher than perceived. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-6JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly positive: Headline inflation was unchanged at 0.4% year-on-year in October. Core inflation however, increased marginally to 0.7% year-on-year in October. Retail sales soared by 9.1% year-on-year in September in anticipation of the consumption tax hike. Industrial production grew by 1.1% year-on-year in September, compared to a contraction of 4.7% year-on-year the previous month. Consumer confidence increased marginally to 36.2 from 35.5 in October. The yen appreciated by 0.5% this week against the U.S. dollar. The BoJ left its policy rate unchanged this Thursday, while reassuring markets that more stimulus could be added if needed in the future. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: On the housing front, nationwide house prices increased by 0.4% year-on-year in October. Mortgage approvals increased marginally to 65.9K in September. Money supply (M4) grew by 4% year-on-year in September, up from 3.3% in the previous month. GfK consumer confidence fell further to -14 in October. The pound appreciated by almost 1% against the U.S. dollar this week. The E.U. has agreed on yet another Brexit extension until January 31st. An earlier exit is also possible if the U.K. so chooses. Meanwhile, the U.K. economy is holding up quite well despite the cloud of uncertainty. We remain tactically long GBP/JPY. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Headline inflation increased to 1.7% year-on-year in Q3, up from 1.6% in the previous quarter. HIA new home sales grew by 5.7% month-on-month in September. Building permits contracted by 19% year-on-year in September. However on a monthly basis, it grew by 7.6% in September. AUD/USD surged by 1.2% this week. During a speech this Monday, RBA Governor Philip Lowe ruled out the possibility of negative interest rates in Australia, and urged businesses to start investing given historically low interest rates. Going forward, we expect the Aussie dollar to rebound amid a global growth recovery.  New Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits increased by 7.2% month-on-month in September. Business confidence came in at -42.4 in October. This was an improvement from -53.5 in the previous month. The activity outlook fell further to -3.5 from -1.8 in October. The New Zealand dollar soared by 0.9% against the USD this week. While we expect the kiwi to outperform the USD amid global growth recovery, it will likely underperform its pro-cyclical peers. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in the Canada have been firm: GDP grew by 0.1% month-on-month in August. Bloomberg Nanos confidence index fell marginally to 57.4 for the week ended October 25th. The Canadian dollar has depreciated by 0.7% against the U.S. dollar, making it the worst performing G-10 currency this week. The BoC decided to keep interest rates on hold this Wednesday, with relatively strong domestic growth and inflation on target. While growth in Canada has surprised to the upside, it might not prove sustainable. We are shorting the Canadian dollar this week against the Australian dollar. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15HF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: KOF leading indicator increased to 94.7 in October, up from 93.9 in the previous month. ZEW expectations fell further to -30.5 in October. The Swiss franc has increased by 0.7% against the U.S. dollar this week. Domestic fundamentals remain strong in Switzerland, but are at risk from the global growth slowdown. As a safe-haven currency, a rising gold-to-oil ratio points to a higher franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.8% year-on-year in September. USD/NOK is flat this week amid broad dollar weakness. The Norwegian krone has diverged from the ebb and flow of energy prices, and is currently trading around two standard deviations below its fair value. While energy prices have recently been soft, the selloff in the Norwegian krone is exaggerated. We are looking to short CAD/NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence rebounded to 92.7 in October. Retail sales increased by 2.6% year-on-year in September. Trade balance of goods shifted back to a surplus of SEK 2 billion in September, following the deficit of SEK 5.5 billion in August. Both imports and exports increased by SEK 6.6 billion and SEK 14.1 billion month-on-month, respectively. USD/SEK fell by 0.6% this week. The Swedish krona is much undervalued. A cheap krona should help to improve the balance of payments dynamics in Sweden. We expect the krona to bounce back sharply once global growth shows more signs of recovery amid a U.S.-China trade war détente. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

  The key question for asset allocators over coming months will be when (or, perhaps, whether) the global manufacturing cycle will turn up. This would trigger a move into more cyclically sensitive markets, for example euro zone equities and Emerging Market assets. It would push up commodity prices and government bond yields, and lead to a weakening of the U.S. dollar. Recommended Allocation Chart 1First Inklings Of A Pick-Up?   For now, the evidence of this turning-point remains ambiguous, and so we hesitate to pull the trigger. BCA Research's calculation of the global OECD Leading Economic Indicator bottomed earlier this year and should lead to a pick-up in manufacturing activity soon (Chart 1). However, only in EM have the manufacturing PMIs bottomed (Chart 1, panel 2) and this was due mainly to a questionably strong September PMI in China which might be reversed when the latest data-point is published on October 1. In the euro zone, the best that one can say is that the PMIs have stopped falling but they remain at a low level (41.9 in Germany, for instance). Some market-based indicators also signal a pick-up – but not yet convincingly (Chart 2). Defensive currencies such as the U.S. dollar and yen have fallen a little against cyclical currencies like the Korean won and Australian dollar. Euro zone equities have shown some strength, especially in the beaten-down auto sector. The global stock-to-bond ratio looks to be about to break out of its recent range. And copper has bounced off its lows. But these moves could turn out to be just noise rather than the beginning of a trend. Chart 2Are Markets Sniffing Out A Turn? Easier financial conditions are the most likely cause of a rebound. BCA Research's Financial Liquidity Index tends to lead both manufacturing activity and the relative performance of global stocks by around 12-18 months (Chart 3). With the dovish turn of central banks this year, the decline in long-term interest rates (the 10-year U.S. Treasury yield, even after its recent rebound, is only at 1.7% compared to 3.2% a year ago), the contraction in credit spreads, and a pick-up in money supply growth especially in the U.S. (where M2 is now growing 6.5% year-on-year), it would be surprising if these looser monetary conditions do not feed through into stronger activity over coming quarters. Chart 3Financial Liquidity Propels Growth Chart 4Could Inflation Now Slow? Indeed, one can easily imagine a scenario next year where growth rebounds but inflation slows (due to the lagged effect of this year’s weaker growth, Chart 4), allowing central banks to remain dovish for some time. This non-inflationary accelerating growth would be highly positive for risk assets and negative for the U.S. dollar. Chart 5 shows how various asset classes behaved in such an environment in the past. Chart 5How Assets Behaved Under Rising Growth/Falling Inflation Easier financial conditions are the most likely cause of a rebound. There are some risks to this optimistic scenario, however. Chinese growth remains sluggish with, for example, imports – the most important factor as far as the rest of the world is concerned – falling by 8.5% year-on-year in September and showing no signs of recovery (Chart 6). The acceleration of Chinese credit growth in early 2019 has petered out since the summer and points to a much flatter recovery of activity than was the case in 2016 (Chart 7). A politburo meeting in late October could lead to monetary stimulus being ramped up but, for now, investors should not assume a big reflationary impulse from China. In the developed world, the biggest risk is that the slowdown in manufacturing spills over into employment, consumption, and services. There are some signs in the U.S. that companies are delaying hiring decisions: job openings have fallen, and the employment component of both the manufacturing and non-manufacturing ISMs points to a deterioration in the labor market (Chart 8). Growing CEO pessimism, presumably because of anemic earnings and the trade war, points to continuing weakness in capex and a further decline in activity indicators (Chart 9). Chart 6Chinese Growth Still Sluggish... Chart 7...As Credit Growth Peters Out   Chart 8Are Firms Starting To Delay Hiring? Chart 9CEOs Are Not Happy Chart 10Stocks Should Outperform Cyclically On balance, we still expect global growth to accelerate next year, and therefore global equities to outperform bonds over the next 12 months (Chart 10). But we want to have greater conviction for that view before we recommend more aggressive pro-cyclical tilts. We remain overweight equities versus bonds, but hedge the downside risk through an overweight in cash, and through tilts towards U.S. equities, and DM over EM equities. We continue to recommend hedging against the upside risk of greater Chinese stimulus and a strong rally in cyclical assets through an overweight in global Financials, Industrials, and Energy, and also through a neutral stance on Australian equities, which are a clean play on a Chinese rebound. We continue to look for the right timing to turn more positive on pure cyclical assets such as euro zone equities, and Emerging Markets. Fixed Income: A cyclical pick-up would imply that global government bond yields have further to rise (Chart 11). Our global fixed-income strategists have a short-term target for the 10-year U.S. Treasury yield of 2.1% (versus 1.7% now) and -0.2% for Bunds (-0.4% now), which would take yields back to their 200-day moving averages (Chart 12).1 We continue to recommend a moderate underweight on duration, and prefer TIPS to nominal bonds, since inflation breakevens imply that the Fed will miss its inflation target by 80 basis points a year on average over the next 10 years. In an environment of accelerating economic growth, credit (both investment grade and high-yield)should outperform in both the U.S. and Europe. The most attractive points on the credit curve are BBB-rated bonds in IG, and the riskiest bonds in HY. For more risk-averse investors, agency MBS currently offer an attractive yield pickup over quality corporate credits. Chart 11Growth Will Push Up Yields Further... Chart 12...Initially To Their 200-Day Average     Equities: Any upside for U.S. equities must come from improved earnings performance. Throughout 2019, earnings have been beating overly pessimistic analysts’ forecasts and Q3 looks to be no exception, with EPS growth on track to be much stronger than the -5% year-on-year that analysts forecast going into the results season (Chart 13). Next year, nominal GDP growth of 4% and a weaker U.S. dollar should produce 7-8% EPS growth. But, with a forward PE of 17x and the Fed unlikely to boost the multiple by further rate cuts, upside is limited. In the right economic environment (as described above), euro zone and EM stocks should do much better. We are currently neutral on euro zone equities, but the recent stronger performance by European banks gives us more confidence that we may be able to move to overweight soon (Chart 14). Similarly, our EM strategists have instituted a buy stop on the MSCI EM index and say they will go overweight EM equities if the index in USD terms rises 3% from its current level.2 Chart 13Analysts Are Too Pessimistic On Earnings Currencies: The first inklings of U.S. dollar weakness over the past month suggest that it may, too, be sniffing out the start of a cyclical rebound, since it tends to be a very counter-cyclical currency (Chart 15). Going forward, relative interest rates are also unlikely to be as bullish a force for the U.S. dollar as they have been in the past few years. For now, we are neutral on the U.S. dollar on a trade-weighted basis, but do see it depreciating against the Australian dollar and the euro over the next 12 months. The British pound has already risen to take into account the lesser probability of a no-deal Brexit, and we would not expect it to move much either way until the General Election result is clear. There are some risks to the optimistic scenario: Chinese growth remains sluggish, and there are signs that U.S. companies are delaying hiring decisions. Chart 14First Signs Of Euro Banks Recovering? Chart 15Recovery Would Be Dollar Bearish Commodities: Industrial metals prices have bottomed out in recent months, in line with Chinese leading indicators (Chart 16). But we will need to see greater Chinese stimulus before we become more positive. Crude oil has moved largely in a range for the past six months, with tightness in supply offset by some weakness in demand, especially from developed economies (Chart 17). With demand likely to pick up in line with the global economy, and supply still constrained by the Saudi/Russia production pact and geopolitical disturbances, our energy strategists see Brent crude averaging $66 a barrel in Q4 and $70 in 2020, versus $60 now. Chart 16Not Enough China Stimulus For Metals To Bounce Chart 17Oil Kept Down By Weak Demand As last year, the Global Asset Allocation service will not publish a Q1 Quarterly in mid-December. Instead, we will send clients on November 22 our annual report of the conversation between Mr and Ms X and BCA Research’s managing editors. This report will detail BCA's house views on the outlook for the macro environment and investment markets in 2020. We will publish GAA Monthly Portfolio Outlooks on the first business days of December and January.   Garry Evans Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1Please see Global Fixed Income Strategy Weekly Report “Big Mo(mentum) Is Turning Positive,” dated 29 October 2019, available at gfis.bcaresearch.com. 2For an explanation, please see the Emerging Markets Strategy Weekly Report " EM Local Bonds: A New Normal?" dated 24 October 2019, available at ems.bcaresearch.com.   Recommended Asset Allocation Model Portfolio (USD Terms)  

Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth   Chart 6China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6).  Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth     Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth.   Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating       Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand.   Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15).     Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives       We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves   Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector   U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018).   Strategy & Market Trends MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades