Economy

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart 2Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

Highlights The Federal Reserve’s 25-basis-point interest rate cut might have disappointed market participants, but Trump’s additional tariffs is a far bigger slap. Our bias is that this is not an escalation in trade tensions. To gauge the dollar’s future path, investors should focus less on what central banks are going to do and more on what will happen to the global manufacturing cycle. The pro-Brexit rhetoric by U.K. Prime Minister Boris Johnson is knocking the pound towards a very compelling buy zone. Sell EUR/GBP at 0.94. Stale longs are currently being flushed out of the gold rally. Trump’s weaponization of the dollar allows investors who missed the first up-leg to accumulate bullion on weakness. Remain short USD/JPY. In the central bank battle towards lower rates, short USD/JPY positions are in an enviable “heads I win, tails I do not lose too much” position. Market volatility is triggering a few stop losses. Stand aside on short CAD/NOK and long AUD/USD. Feature We had the privilege of meeting a few sophisticated investors in South America last week. The general sentiment was cautious in light of the fact that a few end-of-cycle indicators were beginning to flash green. Discussions circled around growth developments in the U.S., the eurozone and China. Even those who have been cautiously optimistic on global growth for some time now are beginning to feel they are waiting for Godot, given the duration of the manufacturing slowdown. South American economies are closely knitted to the Chinese industrial cycle, and so the rising trepidation given credit injections in China should have turned things around by now was both rational and justified. The latest tweets by Trump have done little to alleviate this fear. Our general thesis that a pro-cyclical stance for developed market currencies made sense over the next few months was received with skepticism. The overarching consensus was that the U.S. (and the rest of the world, for that matter) will not go into a recession over the next six-to-12 months, but the dollar will remain in a bull market regardless. We were in agreement that some emerging markets warranted lower currencies versus the dollar, but spent most of our time making the case for a trend reversal in the dollar versus its G10 counterparts. Below is a synopsis of some of our dialogue. Global Growth Remains Weak, But… It is quite remarkable that most investors do not expect a recession in the next six-to-12 months, but expect manufacturing data to keep weakening. If the German manufacturing PMI falls much lower from current levels, Germany will be in deep recession (Chart I-1). What is clear is that this cognitive dissonance is squarely rooted in the recent history of data disappointments, including an escalating trade war. Manufacturing slowdowns have tended to last 18 months peak-to-trough, the final months of which are characterized by fatigue and capitulation. However, unless major imbalances exist (our contention is that so far they do not), mid cycle slowdowns sow the seeds of their own recovery via accumulated savings and pent-up demand. Chart I-1A German Recession? Chart I-2Some Yield Curves Are Steepening The U.S. 10-year versus 3-month curve inverted in March, which has typically heralded a recession over the coming six-to-18 months. The key difference today is that the term premium (compensation that investors receive for holding a long-duration asset) is severely depressed in 10-year notes, making an apples-to-apples comparison with the past more difficult. The two- or five-year Treasury notes, which have both seen similar compression in term premiums, offer more insight, and those curves have not yet inverted (Chart I-2). The recovery could be more L-shaped than V-shaped because of knock-on effects from the trade war and a falling marginal propensity to consume in China.  A pick up in Chinese demand will be critical for a recovery in the global manufacturing cycle. China embarked on massive credit stimulus in March of this year, a development that has been clearly reflected in official loan numbers. If past is prologue, about now is the time that the credit injection should begin to impact underlying data, as the lag is typically six to nine months (Chart I-3). Moreover, the fact that the July manufacturing data were so weak almost guarantees that the next few months will see more aggressive stimulus by the Chinese authorities, and might also explain why China appears so nonchalant to the latest tariffs from the U.S. Chart I-3Chinese Stimulus Works With A Lag A constant pushback we received was that credit stimulus will be much less than in the past, because of structural reform concerns. Also, the recovery could be more L-shaped than V-shaped because of knock-on effects from the trade war and a falling marginal propensity to consume in China. These are obviously very valid concerns. Standard economic theory tells us that unless the trade war degenerates from current levels, the exchange rate should have already adjusted for impending price differentials. Ever since the U.S. began to threaten to impose tariffs on $200 billion worth of goods, the USD/CNY has risen by around 10%. This more than accounts for the notional amount of Chinese exports affected, and is now in the rear-view mirror. The marginal propensity question for China is more difficult to answer because it is only observable ex-post. Think about an economy in recession. The central bank has no idea what proportion of companies are in a liquidity versus a solvency crisis. This is why it keeps injecting stimulus until a few rational players stop deleveraging and start borrowing to invest. Until the cost of capital is lowered to the point where it makes sense for these rational players to invest, the marginal propensity to consume (or invest) will fall. Chart I-4The Euro Zone Manufacturing Recession##br## Is Over We all know that the euro area exports a lot to China. So at times, it is instructive to focus less on what’s happening in China and more on what’s happening to economies highly sensitive to the Chinese pulse. Sweden’s manufacturing new orders-to-inventories ratio is a neat series to track for two reasons. First, Sweden is one of the most export-oriented economies in Europe, selling both to the euro area and outside it. This makes it highly sensitive to the global manufacturing pulse. Second, there are no Chinese credit variables in Sweden’s data, and so it falls outside the judgement call of Chinese reflationary efforts. More importantly, it leads the European PMI tick-for-tick by five months, and so we would be surprised if the eurozone manufacturing recession did not end by the fourth quarter this year (Chart I-4). With new tariffs underway, it will be interesting to see how the balance of forces play out. Bottom Line: In the press conference after the Fed’s rate cut announcement, Fed Chairman Jerome Powell’s delivery was underwhelming, but manufacturing is a small portion of the U.S. economy, suggesting a rate cut was not entirely justified. Going forward, if the Fed delivers less interest rate cuts than is priced in by the market, it is because manufacturing has picked up, which will favor non-U.S. interest rates either way. We are fading the current strength in the dollar as the last hurrah before the ultimate drop. …A Few Tectonic Shifts Are Underway Interest rate differentials have been dictating currency market trends of late, but a few underlying forces that are critical for exchange rates are sending a warning signal for the dollar. Investors are constantly evaluating how to allocate funds, and will rationally deploy capital towards projects that have the highest returns. We know from both the wealth of seminal work that has been done on value investing and from the simple premise that the entry point in any trade could be as important as your entire thesis for that investment, that starting points matter. The starting point for the U.S. is an equity market that is one of the most overvalued, dictating that subsequent returns will pale by historical comparison. The 2017 Trump tax cuts allowed a huge repatriation of capital back to the U.S., to the tune of $400 billion, but that cash is beginning to slowly seep out as high-return projects become more and more difficult to come by (Chart I-5). This may explain why foreigners are stampeding out of U.S. equities, to the tune of about $200 billion a year, not exactly an environment that is conducive for U.S. dollar strength. The reality is that the ebb and flow of U.S. repatriation/outflows have generally captured all the major turning points in the dollar, and there is no reason to believe this time will be different. The ebb and flow of U.S. repatriation/outflows have generally captured all the major turning points in the dollar, and there is no reason to believe this time will be different. The Fed may have delivered a hawkish surprise, and Trump may appear victorious, but confidence in the dollar is fraying at the edges. This can be observed in a falling bond-to-gold ratio. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early 1970s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick-for-tick. U.S. yields might be the only game in town today, but portfolio outflows and a deteriorating balance of payments backdrop will keep longer-term investors on the sidelines (Chart I-6). Chart I-5Investors Are Stampeding Out Of U.S. Assets Chart I-6Confidence In The Dollar##br## Is Falling Data from the World Gold Council this week showed that central banks continued to load up on gold through the first six months of this year. In fact, both China and Russia have been indiscriminate buyers of bullion, irrespective of price, over the past decade. As the amount of negative-yielding debt keeps rising and confidence in the dollar keeps falling, the conditions for a gold bull market become ever-fervent (Chart I-7). Not to mention that many gold buyers have geopolitical concerns against holding dollar liabilities. Finally, long-dollar bets are a much-crowded trade (Chart I-8). In cyclical markets, you are either a contrarian or a victim. One often-asked question on our trip was: For how long have you had a contrarian view on the dollar? The answer is quite simple: As soon as Charts I-1 to I-8 began showing signs of a reversal, which was around a few months ago. Chart I-7Bullion Tailwinds Chart I-8A Crowded Trade Bottom Line: The dollar bull market is late. Watch the AUD/JPY cross, specifically the 72-74 cent zone, for signs of a reversal. A break below will signal we are entering a deflationary bust, while a bounce could be a prelude to a reflationary rally. Housekeeping The stop-loss on our short CAD/NOK position was triggered at 6.65. Two fundamental reasons triggered the stop. First, the U.S. economy has been surprising to the upside relative to that of the euro area. This favors the CAD over the NOK, and the U.S. dollar in general (Chart I-9). Second, oil price differentials have favored the CAD over the NOK, with the WCS-Brent differential narrowing from -$30/Bbl to -$20/Bbl. We are standing aside for now, but will look to put this trade back on in the future. The pro-Brexit rhetoric by U.K. Prime Minister Boris Johnson is knocking the pound towards a very compelling buy zone. Sell EUR/GBP at 0.94. The EUR/GBP is approaching a sell zone (Chart I-10). We will be discussing the pound in an upcoming report, but in the interim please refer to our July 5th bulletin1 for an analysis on cable. Chart I-9Stand Aside On CAD/NOK Chart I-10Sell EUR/GBP At 0.94   Finally, Trump’s rhetoric to step up the trade war in a very nonchalant fashion has nudged us out of our long AUD/USD position. The loss is meaningful, but manageable given the tight stop loss. Stay long AUD/NZD. We will be looking to put back on outright AUD longs soon.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Portfolio Tweaks Into Thin Summer Trading,” dated July 5, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed:  GDP growth fell to 2.1% quarter-on-quarter in Q2, but was stronger than expected. Both headline and core PCE both increased to 2.3% and 1.8% quarter-on-quarter in Q2. Dallas Fed manufacturing business index improved from -12.1 in June to -6.3 in July; Chicago Fed purchasing managers’ index fell to 44.4 in July.  Pending home sales increased by 1.6% year-on-year in June. 156 thousand jobs were created in July according to the ADP report. However, initial jobless claims rose to 215 thousand. Markit manufacturing PMI increased to 50.4 in July, while ISM manufacturing PMI fell to 51.2. It was worrisome that the prices paid index fell from 49.6 to 45.1. DXY index surged by 0.5% this week, the highest since the beginning of the year. The Fed cut interest rates by 25 bps this Wednesday, mainly due to the global downside risks and below-trend inflation. However, his delivery towards further interest rate cuts, should the economy warrant it, was underwhelming. As long as the slowdown in manufacturing does not infect services, this might be a one and done but the insurance guarantee the markets needed from the Fed was poorly telegraphed. Report Links: Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Confidence remains low in July. Consumer confidence came in at -6.6; Services sentiment fell to 10.6; Industrial confidence decreased to -7.4; Business climate fell to -0.12. Q2 GDP growth fell to 1.1% year-on-year. On a quarter-on-quarter basis, it fell from 0.4% to 0.2%. Unemployment rate was steady at 7.5% in June. Headline and core CPI both decreased to 1.1% and 0.9% year-on-year respectively. Markit manufacturing PMI increased slightly to 46.5 in July. EUR/USD plunged by 0.6% this week. The euro area economy expanded by only 0.2% quarter-on-quarter in Q2. Among the European nations, Spain had the highest quarterly GDP growth rate in Q2 at 0.5%, while Italian economy stagnated in Q2. In its meeting last week, the ECB suggested that it stands ready to cut interest rates further and restart its asset purchase program, should the economy warrant it. This is hugely reflationary. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Retail trade yearly growth fell from 1.3% in May to 0.5% in June. The jobs-to-applicants ratio fell slightly to 1.61 in June, while the unemployment rate nudged lower to 2.3% in June. Industrial production contracted by 4.1% year-on-year in June. Housing starts grew by 0.3% year-on-year in June. Consumer confidence fell to 37.8 in July. Nikkei manufacturing PMI fell to 49.4 in July. USD/JPY fell by 1.3% this week. On Tuesday, the Bank of Japan kept interest rates unchanged at -0.1%. In its quarterly outlook, the BoJ cut its inflation forecasts and warned against downside risks to the economy. Kuroda highlighted that additional easing might be required due to increasing exogenous risks: “If Fed moves trigger yen rises, the BOJ could either strengthen forward guidance, allow 10-year bond yields to move in a wider band, or do both.” Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been positive: Mortgage approvals increased to 66.4 thousand in June. Consumer confidence increased from -13 to -11 in July. Nationwide housing prices grew by 0.3% year-on-year in July. Markit manufacturing PMI was unchanged at 48 in July. GBP/USD plunged by 2.6% this week.  On Thursday, the BoE’s Monetary Policy Committee voted unanimously to keep rates unchanged at the current level of 0.75%. Growth forecasts were also cut due to Brexit and global trade blues. With Prime Minister Boris Johnson now in power and his commitment to take Britain out of the European Union, markets are seeing increasing risks of a no-deal Brexit in October. Fortunately, this is knocking cable to compelling buy levels. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: Building permits contracted by 25.6% year-on-year in June, but on a chart looks like a lengthy bottoming process. Headline inflation increased to 1.6% year-on-year in Q2. Australian Industry Group (AiG) manufacturing index increased to 51.3 in July. Terms of trade remain a tailwind for the AUD. Export prices rose by 3.8% in Q2 versus expectations for a 2.8% increase. AUD/USD fell by 1.9% this week. This stands in stark contrast to the Australian equity ASX 200 index that reached a new high this week. An accommodative central bank, skyrocketing iron ore prices and a subtle shift in external demand conditions are fuel for the Australian economy, thus the Aussie dollar. 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 There was scant data out of New Zealand this week: Building permits contracted by 3.9% month-on-month in June. The RBNZ activity outlook fell to 5 in July. Business confidence fell to -44.3 in July from -38.1 in June. NZD/USD fell by 1.4% this week. New Zealand remains vulnerable to exogenous downside risks. The RBNZ is lagging the RBA, in a domestic situation that will eventually culminate into the downturn we have witnessed in Australia. Stay long AUD/NZD. . Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Bloomberg Nanos weekly confidence index fell slightly to 58.2 for the week ending July 26. Industrial product price contracted by 1.4% month-on-month in June. Raw material prices decreased by 5.9% month-on-month in June. GDP growth fell from 1.5% year-on-year in April to 1.4% year-on-year in May. Markit manufacturing PMI increased to 50.2 in July. USD/CAD increased by 0.1% this week. Canadian data was disappointing, but not as much as elsewhere. The First-Time Home Buyers Incentive, scheduled to be launched this September, will allow the government to own 10% equity of the purchased homes in a range of qualified buyers. In the near term, this will cement the floor under CAD. We were stopped out of our short CAD/NOK position this week and are standing aside for now.  Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: KOF leading indicator increased to 97.1 in July. USD/CHF fell by 0.4% this week. We remain positive on the Swiss franc due to the rising market volatility. EUR/CHF has been weakening of late, a trend that might finally catalyze the SNB towards more unconventional policies. In the past, Swiss central bankers have made sizeable gains by de-swaying market participants. With the large euro short positions currently at stake, we will err on the side of caution. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week:  Retail sales contracted by 0.4% in June. USD/NOK rose by 1.8% this week. Oil prices remain volatile as markets await a demand revival. On the supply side, U.S. has posted the seventh consecutive drawdown in inventory. The combination of supply hurdles (Iran and Venezuela production) and rising demand (a pickup in global growth) should underpin the energy market and by extension the Norwegian krone later this year. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Retail sales increased by 3.8% year-on-year in June. Trade balance narrowed to SEK 2.9 billion in June. Non-manual workers’ wages grew by 2.4% in May. GDP growth fell from 2.1% year-on-year in Q1 to 1.4% year-on-year in Q2. Manufacturing PMI was unchanged at 52 in July. USD/SEK increased by 1.7% this week. In June, the Swedish exports decreased to SEK 123 billion from SEK 137 billion in May. The imports also fell from SEK 129 billion in May to SEK 120 billion in June. This further reflects the slowdown in global trading activities. The good news is that the Swedish manufacturing new orders to inventory ratio ticked up in July. Going forward, we will closely monitor the Chinese stimulus, trade talk progresses, and global trade for the direction of the krona. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights So What? Prime Minister Boris Johnson’s threat to take the U.K. out of the EU without a withdrawal deal in place is a substantial 21% risk. Why? The odds of a no-deal exit could range from today’s 21% to around 30%, depending on whether Johnson manages to obtain some concessions from the EU in forthcoming negotiations. It is far too early to go bottom-feeding for the pound sterling, as Brexit risks are asymmetrical. We maintain our tactically cautious positioning, despite some cyclical improvements, due to elevated geopolitical risks in the United States, East Asia, and the Middle East. Feature Thank you Mr. Speaker, and of course I should welcome the prime minister to his place … the last prime minister of the United Kingdom. – Ian Blackford, head of the Scottish National Party in Westminster, July 25, 2019 Chart 1No-Deal Brexit Would Come At A Very Bad Time The Federal Reserve cut interest rates for the first time since the global financial crisis in 2008 on July 31. The Fed suggested that the door is open for future cuts, though Chairman Jerome Powell signaled that the cut should not be seen as the launch of a “lengthy rate cutting cycle” but rather as a “mid-cycle adjustment” comparable to cuts in 1995 and 1998. President Donald Trump responded by declaring a new 10% tariff on $300 billion worth of imports from China! He resumed criticizing Powell for insufficient dovishness – and Trump could in fact fire Powell, though the decision would be contested at the Supreme Court. The Fed’s move shows that Trump’s direct handle on interest rates comes from his ability to control trade policy and hence affect the “the external sector.” The trade war with China has exacerbated a global manufacturing slowdown that is keeping global growth and U.S. inflation weak enough to justify additional rate cuts with each future deterioration (Chart 1). Improvements in global monetary and fiscal policy suggest that the U.S. and global economic expansion will be extended to 2021 or beyond, which is positive for equities relative to government bonds or cash, but we remain defensively positioned in the near-term due to a range of geopolitical risks, highlighted by the new tariffs. The unconvincing U.S.-China tariff ceasefire agreed at the Osaka G20 has fallen apart as we expected; the period of “fire and fury” between the U.S. and Iran continues; and the U.S. is entering what we expect to be a period of socio-political instability in the lead up to the momentous 2020 presidential election. Moreover the risk of a “no deal” Brexit, in which the U.K. exits the European Union and reverts to basic World Trade Organization tariff levels, is rising and will create acute uncertainty over the next three months despite the world’s easy monetary policy settings (Charts 2A & 2B). In June we upgraded our odds of a no-deal Brexit to 21%, up from 7% this spring. While not our base case, the probability is too high for comfort and the critical timing for the rest of Europe warns against taking on additional risk. The risk of a “no deal” Brexit ... is rising and will create acute uncertainty. Chart 2AUncertainty And Sentiment Getting Worse ... Chart 2B... Despite Easy Monetary Policy BoJo’s Gambit Boris Johnson – aka “BoJo” – former mayor of London and foreign secretary, cemented his position as the U.K.’s 77th prime minister on July 24. He immediately launched a gambit to renegotiate the U.K.’s withdrawal. He is threatening not to pay the “divorce bill” (the U.K.’s outstanding budget contributions for the 2014-20 budget period and other liabilities in subsequent decades) of 39 billion pounds. He insists that the Irish backstop (which would keep Northern Ireland or the U.K. in the EU customs union to prevent a hard border between the two Irelands) must be abandoned. He has stacked his cabinet with pro-Brexit hardliners who share his “do or die” stance that Brexit must occur on October 31 regardless of whether an agreement for an orderly exit is in place. These developments were anticipated – hence the decline in our GeoRisk indicator – but the pound sterling is falling now that the confrontation is truly getting under way (Chart 3). Parliament is adjourned in August, so Johnson’s hardline negotiating tactics will get full play in the media cycle until early September, when the real showdown begins. Crunch time will likely run up to the eleventh hour, with Halloween marking an ominous deadline. There is plenty of room for the pound to fall further throughout this period, according to our European Investment Strategy’s handy measure (Chart 4), because the success of Boris’s gambit depends entirely upon creating a credible threat of crashing out of the EU in order to wring concessions that could conceivably pass through the British parliament. Chart 3Our Market-Based Indicator Suggests Still Some Complacency On Brexit Risks Chart 4GBP-EUR Still Has Room To Fall Under BoJo's Gambit Geopolitically, the United Kingdom is not prohibited from exiting the EU without a deal. Though the empire is a thing of the past, the U.K. remains a major world power. It has Europe’s second-largest economy, nuclear weapons, a blue-water navy, a leading voice in global political institutions, and is a close ally of the United States. It mints its own coin. It is a sovereign entity that can survive on its own just as Japan can survive on its own. This geopolitical foundation always supported our view that there was a 50% chance of the referendum passing in 2016, and today it supports the view that fears over a no-deal Brexit are not misplaced. Investors should therefore not confuse Johnson’s bluster with that of Alexis Tsipras in 2015. A British government dead-set on delivering this outcome – given the popular mandate from the 2016 referendum and the government’s constitutional handling of foreign affairs as opposed to parliament – can probably achieve it. However, the probability of a no-deal Brexit may become overstated in the next two-to-three months. Economically and politically, a no-deal exit is extremely difficult to follow through on – hence our 21% probability. Estimates of the negative economic impact range from a 2% reduction in GDP growth to an 11% reduction (Table 1). The 8% drop cited by Scottish National Party leader Ian Blackford in his denunciation of Prime Minister Johnson’s strategy is probably exaggerated. The U.K.’s recorded twentieth-century recessions range from 2%-7% (Chart 5). These offer as good of a benchmark as any. While a no-deal exit is probably not going to create a shock the same size as the Great Depression or the Great Recession, the recessions of 1979 and 1990 would be bad enough for any prime minister or ruling party. Table 1Wide Range Of Estimates For Impact Of No-Deal Brexit A small recession could also spiral out of control – it could create a vicious spiral with the European continent, which is already on the verge of recession. And it could damage consumer confidence more than anticipated – as it would be accompanied by immediate social and political unrest due to the half of the population that opposes Brexit in all forms. Politicians have to pay attention to the opinion polls as well as the referendum result, since opinion polls impact the next election. These show a plurality in favor of remaining in the EU and a strong trend against Brexit since 2017 – a factor that the currency markets are ignoring at the moment (Chart 6). While the evidence does not prove that a second referendum would result in Bremain, it is highly likely that a majority opposes a no-deal exit, given that at least a handful of pro-Brexit voters do not want to leave without a deal. The results of the European parliamentary elections in May (Chart 7) and the public’s preferences for different political parties (Chart 8) both support this conclusion. Chart 6Plurality Of Voters Still Favors Bremain Over Brexit Chart 8Voters Favor Bremain-Leaning Political Parties Parliament is also opposed to a no-deal Brexit. Though the Cooper-Letwin bill that forbad a no-deal exit initially passed by one vote in April (Chart 9A), the final amended version passed with a majority of 309 votes. Further, in July, with the rise of Boris Johnson, parliament passed a measure by 41 votes that requires parliament to sit this fall (Chart 9B), thus attempting to prevent Boris from proroguing parliament and forcing a no-deal Brexit that way. Technically Queen Elizabeth II could still prorogue parliament, but we highly doubt she would intervene in a way that would divide the nation. Johnson himself will have to face the reality of parliament and public opinion. Parliament has one crystal clear means of halting a no-deal exit: a vote of no confidence in Johnson’s government.1 Theresa May only survived her vote of no confidence by 19 seats. Yet Johnson is entering 10 Downing Street at a time when parliament is essentially hung. The Conservative Party’s coalition with Northern Ireland’s Democratic Union Party has been reduced to a majority of two, which is likely to fall to a single solitary seat after the Brecon and Radnorshire by-election, which is taking place as we go to press. Johnson has purged several Tories from his cabinet, and there are a handful of Conservatives who are firmly opposed to a no-deal Brexit. It would be an extremely tight vote as to whether these Tory rebels would be willing and able to bring down one of their own governments – a careful assessment suggests that there are about half a dozen swing voters on each side of the House of Commons.2 But 47 Conservatives contrived to block prorogation (see Chart 9B). The magnitude of the crisis members of parliament would face – an unpopular, self-inflicted no-deal exit and recession – is essential context that would motivate rebellious voting behavior. Parliament’s actions so far, the reality of the economic impact, and the popular polling suggest that MPs are likely to halt the Johnson government from forcing a no-deal exit if he makes a mad dash for it. More likely is that Johnson himself pushes to hold an election after securing some technical concessions from Brussels. He is galvanizing the Conservative vote and swallowing up the single-issue Brexit vote (UKIP and the Brexit Party), while the opposition remains divided between the Labour Party under the vacillating Jeremy Corbyn and the resurgent Liberal Democrats (Chart 10). In a first-past-the-post electoral system, this provides a window of opportunity for the Conservatives to improve their parliamentary majority – assuming that Johnson has renegotiated a deal with the EU and has something to show for it. Chart 10BoJo Could Call Election With Deal In Hand Chart 11Ireland Can Compromise For Stability's Sake This would require the EU to delay the deadline yet again (September 3 is the last date for a non-confidence vote to force a pre-Brexit October 24 election). The European Union has a self-interest in preventing a no-deal Brexit, as it needs to maintain economic stability. It ultimately would prefer to keep the U.K. in the bloc, which means that delays can ultimately be granted, especially to accommodate a new election. As to what kind of compromises are available, the Irish backstop can suffer technical changes to its provisions, time frames, or application. In the end, the Irish Sea is already a different kind of border than the other borders in the U.K. and therefore it is possible to enact additional checks that nevertheless have a claim to retaining the integrity of the United Kingdom. The Democratic Unionists could find themselves outnumbered on this issue. Certainly the Republic of Ireland has an interest in preventing a no-deal Brexit as long as a hard border with Northern Ireland is avoided, and Boris Johnson maintains that it will be (Chart 11). The risk of a no-deal Brexit is around 21% Our updated Brexit Decision Tree in Diagram 1 provides the outcomes. Former Prime Minister Theresa May failed three times to pass her Brexit deal. We allot a 30% chance, higher than consensus, that Boris Johnson can do it through galvanizing the Conservative vote – given that he is operating with a hung parliament and is at odds with the median voter on Brexit. We give 21% odds to a no-deal Brexit based on the difficulty of parliament outright halting Johnson if his government is absolutely determined to follow through with it. This is clearly a large risk but not our base case. We would upgrade these odds to around 30% in the event that negotiations with the EU completely fail to produce tangible outcomes. It is far more likely that a delay occurs and leads to new elections (49%) – and these odds rise to 70% if Johnson fails to extract concessions from the EU that enable him to pass a deal through parliament. Diagram 1Brexit Decision Tree (Updated As Of June 21 For Boris Johnson) A final constraint on Johnson comes from Scotland, as highlighted in the epigraph at the top of the report: the demand for a new Scottish independence referendum is reviving as a result of opposition to Brexit in general and specifically to Prime Minister Johnson’s hardline approach (Charts 12A & 12B). The SNP is also improving its favorability among Scottish voters relative to other parties (Chart 13). We have highlighted this risk in the past: support for Scottish independence does not have a clear ceiling amid the antagonism over Brexit, especially if an economic and political shock hits the union as a result of a forced no-deal exit. Chart 13Scottish Nationals Resurgent Bottom Line: The risk of a no-deal Brexit is around 21%, though a complete failure of negotiations with the EU could push it up to 30%. If it occurs it will induce a recession and eventually could result in the breakup of the union with Scotland. China And Investment Recommendations What can investors be certain of regardless of the different Brexit outcomes? The United Kingdom will reverse the fiscal austerity of recent years (Chart 14). Fiscal stimulus will be necessary either to offset the shock of a no-deal exit in the worst-case scenario, or to address the ongoing economic challenges and public grievances in a soft Brexit or no Brexit scenario. These grievances stem from the negative impact on the middle class of globalization, post-financial crisis deleveraging, low real wage growth, and the decline in productivity. Potential GDP growth is set to fall if immigration is curtailed and restrictions on trade with the EU go up. The government will have to offset this trend with spending to boost the social safety net and encourage investment. Chart 14Fiscal Austerity To Go Into Reverse The pound is clearly weak on a long-term and structural basis (Chart 15). Based on our assessment of the British median voter – opposed to a no-deal Brexit – and the fact that parliament is also opposed to a no-deal Brexit Chart 15Deep Value In Sterling and is the supreme lawgiving body in the British constitution, we expect that an enormous buying opportunity will emerge when Prime Minister Johnson’s gambit has reached its apex and he is either forced to accept what concessions the EU will give. But if forced out of office, election uncertainty due to a potential Prime Minister Jeremy Corbyn will prolong the pound’s weakness. Brexit is not the only risk affecting Europe this summer – a critical factor is Europe’s own economic status, which in great part hinges on our China view (Chart 16). The Chinese Communist Party’s mid-year Politburo meeting struck a more accommodative tone relative to the April meeting that sounded less dovish in the aftermath of the Q1 credit splurge. The emphasis of the remarks shifted back to the need to take additional measures to stabilize the economy, as in the October 2018 statement. This fits with our view since February that Chinese stimulus will surprise to the upside this year. Chart 16Chinese Reflation Positive For Europe Policymakers’ efforts are working thus far, with signs of stabilization occurring in the all-important labor market (Chart 17). There is some evidence that Xi Jinping’s anti-corruption campaign is moderating, which also supports the view that policy settings in the broadest sense are becoming more supportive of growth (Chart 18). Chart 17China Will Reflate More Chart 18Relaxing Anti-Corruption Campaign Another Form Of Easing Chart 19Hong Kong Equities Have Farther To Fall We still are long European equities versus Chinese equities and are short the CNY-USD. From a geopolitical point of view, the U.S.-China conflict is intensifying with President Trump’s threat to raise an additional 10% tariff on $300 billion of Chinese imports despite the resumption of talks. In addition, the Hong Kong protests are intensifying, with China’s People’s Liberation Army (PLA) warning that it may have to intervene. There is high potential for violence to erupt, leading to a more heavy-handed approach by Hong Kong security forces and even eventual PLA deployment. This suggests there is downside in the Hang Seng index (Chart 19) – and PLA intervention could lead to broader investor concerns about China’s internal stability and another reason for tensions with the United States and its allies. The U.S.-China conflict is intensifying. Our alarmist view on Taiwan in advance of the January 2020 election is finally taking shape. Not only has the Hong Kong unrest prompted a notable uptick in Taiwanese people’s view of themselves as exclusively Taiwanese (Chart 20), but Beijing has also announced additional restrictions on travel and tourism to Taiwan – an economic sanction that will harm the economy (Chart 21). These actions and escalation in Hong Kong raise the odds that the ruling Democratic Progressive Party will remain in power in Taiwan after January and hence that cross-strait relations (and by extension Sino-American relations) will remain strained and will require a higher risk premium to be built in. The latest trade war escalation could easily spill into strategic saber-rattling, as the U.S. blames China for North Korea’s return to bad behavior and China blames the U.S. for dissent in Hong Kong and likely Taiwan. Chart 21Beijing To Sanction Taiwan Tourism Again The U.S.-China trade negotiations are falling apart at the moment. We had argued that China’s stimulus and stabilization would create a negative reaction from President Trump, who would regret the Osaka ceasefire when he saw that China’s bargaining leverage had improved. This has come to pass, vindicating our 60% odds of an escalation post-G20. The U.S. Commerce Department could still conceivably renew the Temporary General License for U.S. companies to deal with Chinese tech firm Huawei on August 19, in order to create an environment conducive to progress for the next round of trade talks in September, but with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling. China’s new announcements regarding reforms to make local officials more accountable and to make it easier for companies to go bankrupt, including unprofitable “zombie” state-owned enterprises, could be a thinly veiled structural concession to the United States, but it remains to be seen whether these will be implemented and reinforced. Beijing rebooted structural reforms at the nineteenth national party congress but we expect stimulus to overwhelm reform amid trade war. We are converting our long non-Chinese rare earth producers recommendation to a strategic trade, after it hit our 5% stop-loss, as it is supported by our major theme of Sino-American strategic rivalry. The secular nature of this rivalry has been greatly confirmed by the fact that President Trump is now responding to American election dynamics. The U.S. Democratic Party’s primary debates have revealed that the candidates most likely to take on President Trump (Bernie Sanders and Elizabeth Warren) are adopting his hawkish foreign policy and trade policy stance toward China. The frontrunner former Vice President Joe Biden is the exception, as he is maintaining President Obama’s more dovish and multilateral approach. Trump’s clear response is to ensure that he still owns the trade and manufacturing narrative, to call Biden weak on trade, and to prevent the left-wing populists from outflanking him. Short the Hang Seng index as a tactical trade and close long Q1 2020 Brent futures versus Q1 2021 at the market bell tonight.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Maddy Thimont Jack, “A New Prime Minister Intent On No Deal Brexit Can’t Be Stopped By MPs,” May 22, 2019, www.instituteforgovernment.org.uk. 2 See Dominic Walsh, “Would MPs really back a no confidence motion to stop no-deal?” The New Statesman, July 15, 2019, www.newstatesman.com.

Dear Client, Next week I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Amr answers some key questions that clients have been asking about Japan recently: Does the Bank of Japan have any monetary policy ammunition left? How hard will October’s tax hike hit consumption? Has Japan’s corporate governance improved meaningfully? Is there a case for a rerating of Japanese equities? I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Highlights Risk assets are likely to struggle over the next few weeks as investors digest both the decision by President Trump to further raise tariffs on Chinese imports, and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. Despite the bluster from the Trump Administration, a trade deal between the U.S. and China is still more likely than not. The failure to reach a deal would weaken the U.S. economy, hurting Trump’s reelection prospects. Reassuringly, there is scant evidence that the global manufacturing downturn has infected the service sector to any significant degree. This is true not just for the U.S., but for manufacturing-intensive economies such as Germany as well. The share of manufacturing in both GDP and employment has fallen steadily around the world. Manufacturing output has also become less volatile over time, and less correlated with service sector growth. As global manufacturing activity starts to recover later this year, earnings growth will pick up. Stay overweight global equities relative to bonds on a 12-month horizon, while preparing to increase exposure to EM and European stocks. Feature First The Fed, And Then Trump Risk assets got hit by a one-two punch this week. First, the Federal Reserve dashed investors’ hopes for an extended easing cycle. While the Fed did cut rates by 25 basis points and pledged to end its balance sheet runoff in August (two months earlier than previously indicated), Jay Powell’s characterization of the Fed’s current mantra as a “mid-cycle adjustment to policy” suggested that further cuts were far from guaranteed. To reinforce the point, Powell stated that the Fed was not at “the beginning of a lengthy cutting cycle.” “That’s not our perspective now, our outlook,” he added. Contributing to the hawkish backdrop, Esther George, the president of the Kansas City Fed, and Eric Rosengren, the once fairly dovish president of the Boston Fed, voted to keep rates unchanged. Equities initially plunged on Wednesday following Chair Powell’s press conference. Markets rallied back Thursday morning, only to tumble again in the wake of President Trump’s decision to further raise tariffs on Chinese imports. There is no shortage of theories purporting to explain the timing of Trump’s decision. Was he trying to send a message to the Fed that it had better keep easing? Was he annoyed that Elizabeth Warren, Bernie Sanders, and a number of other presidential contenders tried to outflank him on trade during the Democratic debate the prior evening by suggesting he was not protectionist enough? Regardless, risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. While a severe escalation of the trade war would tip the scales towards recession, the risk of such an outcome remains low. Negotiations with China are ongoing. The threat to further raise tariffs in September is consistent with the “maximum pressure” doctrine that has governed Trump’s policy decisions. Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s reelection prospects. The fact that the latest tranche of tariffs, unlike previous ones, will fall mainly on consumer goods could further hurt Trump in the polls. He does not want that. The Manufacturing Cycle: How Low Will It Go? Chart 1The Global Manufacturing Cycle Has Likely Reached A Bottom Trade tensions have undoubtedly exacerbated the global manufacturing downturn. However, trade policy hasn't been the only culprit, as evidenced by the fact that manufacturing activity began to decelerate even before the trade war heated up in earnest. As we explained in detail last week,1 manufacturing activity tends to follow a “natural cycle” lasting about three years, with output growth rising for the first 18 months, and falling for the next 18 months (Chart 1). The latest downleg began at the start of 2018. Thus, as long as the trade war does not spiral out of control, we should soon see a bottom in the manufacturing cycle based on this timing. For now, the evidence for such a bottom remains mixed. It is encouraging that data released this week showed an improvement in the Chinese Caixin Manufacturing PMI and a slight uptick in the new orders component of the U.S. ISM manufacturing survey. Nevertheless, both surveys remain weak in absolute terms. Meanwhile, the European PMIs have continued to deteriorate, taking the global manufacturing PMI down to 49.3 in July, the lowest level since October 2012.  What one can say more definitively is that at least so far, the manufacturing downturn has not infected the service sector to any significant degree (Chart 2). The U.S. non-manufacturing ISM will be released on Monday, but the June reading of 55.1, while below year-ago levels, was still in the middle of its historic range (Chart 3). Chart 2AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 2BThe Service Sector Has Softened Much Less Than Manufacturing (II)   Chart 3U.S. ISM Non-Manufacturing Still Close To Its Historic Average Strong demand for services has underpinned U.S. employment growth which, in turn, has supported consumption growth. Real PCE rose by 4.3% in Q2. The jump in the Conference Board’s index of consumer confidence in July suggests that U.S. consumers remain upbeat. Notably, the services PMI has increased in the euro area this year, even as the manufacturing sector has weakened there. In Germany, where the manufacturing PMI plunged to 43.2 in July, the non-manufacturing PMI still managed to clock in at 55.4, up from 51.8 in December 2018. Manufacturing: A Canary In The Coal Mine Or Just A Coal Mine? The fact that the overall German economy has not come crashing down despite its high reliance on manufacturing is reassuring. Nevertheless, many investors remain convinced that it is just a matter of time before manufacturing woes precipitate a broad-based economic downturn. Such concerns are well founded if protectionism causes the entire global trading system to come crashing down. However, provided that this does not occur, it is unlikely that slower manufacturing growth, in and of itself, will trigger a recession. Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. Contrary to conventional wisdom, there is little evidence that manufacturing leads the broader economy. Chart 4 clearly shows that manufacturing output tracks overall real GDP growth, with no clear lead-lag relationship. Chart 4Manufacturing Activity Moves In Sync With The Broad Economy Granted, manufacturing growth is more volatile than GDP growth, but that is simply because of the nature of manufacturing production. More than half of manufacturing output consists of durable goods. Purchases of durable goods tend to be lumpy over time. When unemployment starts to rise, households typically postpone purchases of, say, refrigerators and automobiles, while businesses postpone purchases of capital goods. As inventories pile up, manufacturers respond by cutting output. The opposite happens during expansions. The Declining Role Of Manufacturing In The Economy As a share of GDP, global manufacturing output currently stands at 16%. The manufacturing share has been trending lower in most countries (Chart 5). In the U.S., where the data goes back much further, manufacturing output has declined from over 25% of GDP in the 1950s to 11% of GDP at present. The share of manufacturing jobs in total employment has dropped in tandem (Chart 6). Chart 5The Declining Role Of Manufacturing Is A Global Phenomenon Chart 6The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling   The volatility of manufacturing growth rates has also fallen over time. This has occurred partly because of better inventory management techniques. Chart 7 shows that the ratio of real nonfarm inventories-to-domestic sales of goods and structures has been trending lower for the past 40 years. Diminished fears of oil embargos and price controls, which were rampant during the 1970s, have also allowed inventory levels to come down. Chart 7A Structural Decline In The Inventories-To-Sales Ratio Starting In The Early 1980s As manufacturing has become a smaller and less volatile part of the economy, its impact on the service sector has diminished. In fact, we estimate that all of the reduction in the variance of U.S. private sector GDP growth over the past 50 years can be attributed to a smaller contribution from the goods-producing sector, as well as a decline in the correlation between goods-producing and service-producing industries (Chart 8). Investment Conclusions Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. As long as the trade war does not boil over, global manufacturing activity should recover during the remainder of this year, boosting corporate earnings in the process. More cyclically-oriented stock markets and sectors will benefit the most. Non-U.S. stocks have the advantage of trading at a substantial discount to their U.S. peers. Chart 9 shows that U.S. stocks trade at 17.5-times forward earnings, while non-U.S. stocks trade at only 13.5-times forward earnings. We expect to upgrade European and EM equities over the coming months. Chart 9AEquities: Better Valuations Outside The U.S. (I) Chart 9BEquities: Better Valuations Outside The U.S. (II) Better global growth prospects should cause the dollar to weaken. Stronger growth should also allow government bond yields to rise and yield curves to steepen. Investors should favor stocks over bonds for the next 12 months. Housekeeping: We were stopped out of our long EUR/JPY trade for a loss of 5%. We will consider reopening this trade once market volatility settles down.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Chart 1Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data   Chart 5China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Much like the rest of the global economy, oil markets await the lift in demand that fiscal and monetary stimulus have delivered in the past. As the debate among BCA Research’s strategists demonstrated, this is not a given. Uncertainty over the effectiveness of these policy responses will remain elevated as 2H19 evolves.1 For our part, we expect global stimulus – led by easing financial conditions in the U.S. and China – will reboot demand. On the supply side, we expect OPEC 2.0 production discipline and capital-constrained U.S. shale-oil production to keep output growth just below demand growth for the next year (Chart of the Week, top panel).2 Markets arguably have not been on the same page as us for the past two months or so, and appear to be pricing in supply-demand assumptions similar to those contained in the U.S. EIA’s latest Short-term Energy Outlook (STEO).3 These generate lower forecasts – $61/bbl and $57/bbl – than the $75/bbl and $70/bbl we expect for Brent and WTI next year, when we run them through our fundamental econometric model (Chart 2). Chart of the WeekOil Supply - Demand Balance Will Continue To Tighten We argue below the EIA’s assumptions are consistent with current price levels, but inconsistent with current Brent and WTI forward curves. We remain long September – December 2019 Brent vs. short September – December 2020 Brent, which is up 76% since inception February 28, 2019, and long 1Q20 vs. 1Q21 Brent, which is up 39% since inception July 18, 2019, in anticipation of steeper backwardations. We also expect the combination of global fiscal and monetary stimulus, along with the aforementioned production constraints, will lift price levels in line with our forecasts. Highlights Energy: Overweight. In line with our expectation, U.S. crude oil inventories drew 8.5mm barrels last week, posting a record seventh consecutive draw. Last week’s inventory drawdown follows a massive draw in crude oil of close to 11mm barrels the previous week. Base Metals: Neutral. Spot treatment and refining charges (TC/RC) for copper fell to $51.20/MT last week, the lowest reading since the launch of Fastmarkets MB’s Asia-Pacific index in 2013. This is consistent with tighter spot supplies – low TC/RC levels mean demand for spot refining services is weak due to low concentrate supply. Our long Dec19 $3.00/lb calls vs. short Dec19 $3.30/lb call on the COMEX was stopped out after hitting our -15% stop-loss limit. We remain bullish and will re-visit this recommendation in the near future. Precious Metals: Neutral. Gold prices remain well supported by global monetary accommodation, as seen this week following the Fed’s decision to lower its policy rate by 25bps to 2.25%. We expect another “insurance cut” later this year, and remain long gold, which is up 12% this year as central banks scramble to redress tightening financial conditions globally. Ags/Softs: Underweight. 54% of the U.S. soybean crop was rated in good or excellent condition in states accounting for 95% of bean acreage. Last year at this time, 70% of the crop was rated good or excellent, according to the USDA’s Crop Progress Report. Feature The oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. Easing financial conditions in the U.S. and China, along with higher fiscal outlays globally, are necessary and likely sufficient to reboot global oil demand, in our assessment of fundamentals.4 On the supply side, our modeling assumes OPEC 2.0’s production discipline and capital-constrained U.S. shale-oil production will be sufficient to keep output growth just below demand growth for the next year.5 Chart 2Oil Markets Pricing Weaker Fundamentals Than BCA Expects In our modeling, these supply-demand effects combine to lift prices, and to further backwardate the Brent and WTI forward curves as global storage levels fall, as the top panel of Chart 2 shows. However, as the bottom panel of Chart 2 illustrates, the oil market presently is pricing to a weaker set of fundamentals, which are very close to those assumed by the U.S. EIA in its monthly STEO forecast. The EIA assumes demand growth of 1.1mm b/d this year, versus our assumption of 1.25mm b/d, and 1.4mm b/d next year, versus our 1.5mm b/d assumption. When we push the EIA’s assumptions through our fundamental supply-demand-inventory model, we get average Brent prices of $64/bbl this year and $61/bbl in 2020, versus our expectations of $70/bbl this year and $75/bbl next year for Brent.6 For WTI, the EIA’s fundamentals produce prices of $57/bbl in 2019 and $57/bbl in 2020, versus our expectation of $63/bbl and $70/bbl. Whither Storage? The EIA’s supply-demand fundamentals produce price levels closer to where the market is trading currently, when we run them through our fundamental model. However, they are not consistent with forward-curve dynamics, which presently are backwardated. Using the EIA’s supply and demand assumptions for this year and next in our econometric model produces an increase in oil inventories, which grows next year, as opposed to our expectation inventories will shrink over the course of the next year (Chart 3, bottom panel). If the EIA’s expectation for inventories was shared by market participants, Brent and WTI forward curves would be in contango, not backwardation as they are presently. In this respect, our estimates are more consistent with current forward-curve dynamics (Chart 3, top panel). Chart 3Inventories Swell Assuming EIA's Supply-Demand Fundamentals Chart 4Crude Inventories' Days-Forward-Cover This also can be seen in an analysis of days-forward-cover (DFC) dynamics, in which we compare deviations from the five-year average (trend) number of days’ worth of demand that can be covered by current inventory levels (Chart 4). Our assumptions produce deviations that align with the differentials between prompt and deferred futures contracts, which measures the backwardation and contango in Brent and WTI markets. The implied DFC ratio that falls out of running the EIA’s supply-demand assumptions in our fundamental model shows inventories in 2020 level out, even as market participants continue to price in a backwardated forward curve for Brent and WTI.7 If we are correct in our assessment of inventories, Brent volatility will increase next year as inventories and DFC fall (Chart 5).   Whither Global Trade, Manufacturing? As we’ve noted above, the next few months will provide important information to markets and policymakers alike, as both wait to see whether the concerted monetary policy efforts aimed at reviving the real economy – manufacturing, in particular – will be effective. As an aside, uncertainty regarding the effectiveness of what, in the not-too-distant past, was considered standard macroeconomic stimulus is not restricted to market participants and practitioners. Central banks, and the economics profession itself are in the midst of a fundamental rethink of its foundational assumptions and models, and will be dialed in on this entire process.8 We continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. The global manufacturing slowdown in 1H19 is confirmed in EM trade data (Chart 6). This has the potential to continue if the Sino-U.S. trade war retards capex and durable-goods spending. The IMF notes the linkage between manufacturing and global trade exists because trade includes a lot of durables, which are energy-intensive in their production and transportation.9 Again, the big unknown here is whether the fiscal and monetary stimulus in systematically important economies will be sufficient to revive manufacturing globally and commodity demand, particularly for energy. There is enough cognitive dissonance around the effectiveness of monetary policy – and the channels through which it operates – to give even a hardened monetarist pause. If, as we expect, U.S. monetary stimulus succeeds in weakening the USD, global trade and EM GDP levels can be expected to increase.10 This will be supportive of commodity demand generally, oil demand in particular. In a simulation of oil prices as a function of the broad trade-weighted USD, we found Brent prices could rally sharply on a 10% depreciation between now and end-2020 (Chart 7). Chart 6Fiscal and Monetary Stimulus Will Lift Global Trade and Manufacturing Chart 7Fed Policy Should Weaken USD, Boost Oil Demand Such a rally is unlikely to occur due to USD weakness alone, given the mitigating factors observed in recent excursions above $80 Brent. OPEC 2.0 likely would raise production as prices moved through $80/bbl, and we expect demand destruction in EM economies would quickly follow, due to the removal of fuel subsidies in many EM economies. These supply-demand responses would push prices lower after a few months. However, this exercise is worthwhile in forming an expectation around successful Fed stimulus, given the long-term equilibrium between the broad USD TWIB and oil prices since 2000. This analysis also suggests there is a role for OPEC 2.0 in increasing production, if systematically important central banks succeed in reviving global demand, and the Fed can lower the USD TWIB. Keeping production too low at that point would be self-defeating for the coalition. Successfully managing this balance would support EM GDP growth and, in so doing, lift commodity demand. Bottom Line: Oil prices are trading to lower expected levels of demand and higher supply than we currently are using in our forecasts. However, we continue to expect demand to revive on the back of global monetary and fiscal stimulus, and for supplies to be constrained this year and next. As such, we are maintaining our expectation Brent crude will average $70 and $75/bbl this year and next, with WTI trading $7 and $5/bbl lower, respectively. We also expect these forces to steepen the backwardation in Brent and WTI forward curves this year and next. Big policy issues – the Sino-U.S. trade war, U.S.- Iran tensions in the Persian Gulf, uncertainty around how the crisis in Venezuela is resolved – still dog markets, as do persistent doubts re the effectiveness of monetary policy.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see What Goes On Between Those Walls? BCA’s Diverging Views In The Open, a Special Report published by BCA Research July 19, 2019. It is available at bca.bcaresearch.com. 2      OPEC 2.0 is the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was founded in 2016 to reduce global oil inventory levels bloated by a market-share war launched by the original OPEC cartel in 2014. Backwardation is a term of art in commodity markets, which describes a forward curve in which prompt prices exceed deferred prices. The opposite of backwardation is contango. 3      The U.S. Energy Information Administration’s Short-term Energy Outlook is published monthly. 4      Please see Weak 1H19 Oil Demand Data Fuels Market Uncertainty, published July 18, 2019, for our latest forecast. 5      NB: Our forecast for U.S. shale-oil production includes the drawdown of excess drilled-but-uncompleted (DUC) wells, especially in the Permian as pipeline constraints are removed this year. Recent reports have suggested DUC excess inventory is over-estimated in EIA data we use in our models, and that more wells than actually are reported by the EIA are required to produce the volumes reported for the Permian Basin. Please see Analytics Firm: Permian Fracturing Work Underreported by 21% in 2018 published by the Journal of Petroleum Engineering July 24, 2019. 6      The EIA’s forecast calls for Brent to average $67/bbl in 2H19 and for all of 2020, and for WTI to trade $5/bbl and $4/bbl under Brent in 2H19 and 2020, respectively. For 2H19, we expect Brent to trade at $74/bbl; we expect WTI to trade $7/bbl below Brent in 2H19 and $5/bbl lower in 2020. 7      We assume OPEC 2.0 will need to increase production in 2H20, to keep inventories from falling so low that Brent prices risk breaching $80 - $85/bbl, which we view as the no-go zone the producer coalition is most sensitive to. 8      Please see Rebuilding macroeconomic theory Volume 34, Issue 1-2 of the Spring-Summer 2018 issue of the Oxford Economic Policy Review for an excellent treatment of this effort. The Fed also is examining how it conducts monetary policy, in an effort led by Vice Chair Richard Clarida. The initial research goals were laid out in November 2018, when the Fed announced it would be conducting a comprehensive review of its monetary policy strategy, tools, and communication practices. In June of this year, the Fed followed through with a two-day symposium to discuss many of the topics we routinely address in our publications. Prof. Maurice Obstfeld of Berkeley’s Global Dimensions of U.S. Monetary Policy was an insightful paper re how U.S. monetary policy affects global growth; Prof. Kristin Forbes of MIT’s discussion also was excellent, and highlighted the role of commodity markets in this framework. 9      Please see Still Sluggish Global Growth in the IMF’s World Economic Outlook Update, published July 23, 2019. The Fund lowered its global growth forecast slightly, and cautioned, "GDP releases so far this year, together with generally softening inflation, point to weaker-than-anticipated global activity. Investment and demand for consumer durables have been subdued across advanced and emerging market economies as firms and households continue to hold back on long-term spending. Accordingly, global trade, which is intensive in machinery and consumer durables, remains sluggish. The projected growth pickup in 2020 is precarious, presuming stabilization in currently stressed emerging market and developing economies and progress toward resolving trade policy differences." 10     These variables are intimately connected. Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah published by BCA Research’s Global Investment Strategy June 28, 2019, for our House view on global growth, interest rates and the expected evolution of the USD. It is available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades  

Special Report

Highlights China’s infrastructure investment growth rate could rebound moderately from its current nominal 3% pace, but will remain well below the double-digit rate it has registered for most of the past decade.  A lack of funding for local governments and their financing vehicles will somewhat cap the upside in infrastructure fixed-asset investment (FAI) in the next six to nine months. Special bond issuance will be insufficient to ensuring a major recovery in infrastructure spending. Investors should tread cautiously on infrastructure plays in financial markets. Feature Chart I-1Chinese Infrastructure Investment: Double-Digit Growth Again? Nominal infrastructure investment growth in China has slowed from over 15% in 2017 to 3% currently (Chart I-1). This is the weakest growth rate since 2005 excluding the late 2011-early 2012 period. Over the past decade, each time the Chinese economy experienced a considerable slowdown, infrastructure construction was ramped up to revive growth. Infrastructure spending growth skyrocketed in 2009 and was also boosted in 2012. In 2015-2016, it was not allowed to decelerate with the issuance of nearly RMB 2 trillion of special infrastructure bonds. This time the government has also reacted. Since mid-2018, the Chinese authorities have dramatically raised local governments’ special bonds balance limits, prompted local governments to front-load their issuance this year, and also encouraged the private sector to participate in public-private partnership (PPP) infrastructure projects. Will Chinese infrastructure FAI growth accelerate over the next six to nine months from its current nominal 3% pace to double digits? The short answer is no. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. For purposes of this report, the composition of “infrastructure” includes three categories – (1) Transport, Storage and Postal Service, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas & Water Production and Supply. Chart I-2 presents the breakdown of the nominal infrastructure FAI by category. Funding Constraint Preceding both the 2011-2012 and 2018 infrastructure investment slumps, the Chinese central government increased its scrutiny on local government debt and tightened funding conditions for infrastructure projects. As a result, all three categories of infrastructure spending experienced a sharp deceleration (Chart I-3). Overall, financing and qualitative limitations that Beijing imposes on local government infrastructure spending hold the key to the outlook. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. Looking forward, without a considerable recovery in available financing, there will be no meaningful rebound in Chinese infrastructure investment and construction activity. For now, we are not very optimistic on financing. Chart I-4 shows the breakdown of the major funding sources of Chinese infrastructure investment. All of them are likely to face considerable funding constraints over the next six to nine months. Chart I-3Chinese Infrastructure Investment Growth Has Decelerated Across The Board   1. Self-Raised Funds Self-raised funds contribute nearly 60% of overall infrastructure funding. They include net local government special bond issuance, PPP financing and government-managed funds’ (GMFs) revenues excluding proceeds from special bond issuance. A. Local government special bond issuance, which is exclusively used to fund infrastructure projects, has been the major source of financing for local governments in the past 12 months. The authorities significantly boosted net local government bond issuance to RMB 1.2 trillion in the first six months of this year from only RMB 361 billion in the same period in 2018. However, the amount of special bond issuance in the second half of this year will unlikely be significant enough to boost infrastructure FAI greatly. First, the central government has not only set a limit on the aggregate local government special bond balance, but it also set limits for each of the 31 provinces/provincial-level cities.1 In the past three years, nearly all provinces did not use up their special bond issuance quotas. This resulted in an outstanding aggregate amount of special bonds of only about 85% of the limit.2 In both 2017 and 2018, local governments were left with RMB 1.1 trillion special bond issuance quota unused for that year. Second, based on the limit on outstanding amount special bonds set by the central government for the end of 2019, local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of this year. In comparison, in 2018, the issuance was heavily concentrated in the second half of the year with RMB 1.6 trillion. Our estimate shows there will be only RMB 400-600 billion increase in net total special bond issuance in 2019 versus 2018.3 This will translate into a merely 2-3% growth in Chinese infrastructure investment. Third, net local government special bond issuance made up only 15% of overall infrastructure FAI over the past 12 months. Hence, there is still a huge financing gap to be filled (Chart I-5). B. Public-private partnerships (PPP) are unlikely to meet the financing shortage either. PPPs have become an important financing model for Chinese local governments to fund infrastructure investments since 2014. Nevertheless, to control rising local government debt risks, the central government has tightened regulations on PPP projects since early last year. A series of tightened rules have resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPPs contributions to total infrastructure FAI have plunged from over 30% in 2017 to 10% currently (Chart I-6). Chart I-5Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Chart I-6Public-Private Partnerships: Too Small To Meet The Financing Shortage   So far, the rules on PPP projects on local governments remain tight. In March, the central government tightened its rule on local government participation in PPP projects. The new rule states that, if a local government has already spent more than 5% of its overall general expenditures on PPP projects excluding sewage and waste disposal PPP projects, it will not be allowed to invest in any new PPP projects. Before March, the threshold was over 10%. In early July, the National Development and Reform Commission (NDRC) demanded all PPP projects undertake a thorough feasibility study. The NDRC emphasized that PPP projects that do not follow standard procedures will not be allowed. Chart I-7Government-Managed Funds: Headwinds From Falling Land Sales C. Government-managed funds (GMF) excluding special bond issuance accounts, which contribute about 15% of overall infrastructure financing, are also facing constraints. According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures of the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. Land sales by local governments are one major revenue source for GMFs. Contracting property floor space sold is likely to depress real estate developers’ land purchases, further reducing local governments’ revenues from selling land (Chart I-7). This will curb local governments’ ability to finance their infrastructure projects through GMFs. 2. Domestic Loans Domestic loans contribute to about 15% of overall infrastructure financing. Infrastructure projects are generally long term in nature. Presently, the impulse of non-household medium- and long-term (MLT) lending has stabilized but has not yet improved (Chart I-8). While not all of MLT loans are used for infrastructure, sluggish MLT lending reflects commercial banks’ reluctance to finance infrastructure projects. We believe a decelerating economy, mounting local government debt, and often-low returns on infrastructure projects will continue to constrain loan funding of infrastructure projects from both banks and the private sector. 3. General Government Budget The general government budget (which includes central and local governments) accounts for about 15% of overall infrastructure financing. The general budget is also facing headwinds from declining revenue due to recent tax cuts and lower corporate profit growth (Chart I-9). Chart I-8Sluggish Medium/Long-Term Bank Lending Chart I-9Government General Budget: Large Deficit   Bottom Line: Funding constraints will likely linger, making any recovery in Chinese infrastructure investment growth moderate over the next six to nine months. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. While local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of 2019, it would be well below the RMB 1.4 trillion of special bond issuance that was rolled out in the second half of 2018. FAI In Transportation: In Nominal Terms… The transportation sector accounts for about 31% of total Chinese infrastructure investment. It includes railway, highway, urban public transit, air and water transport. Table I-1 shows the 13th five-year (2016-2020) transportation investment plan released by the government in February 2017,4 which excludes urban public transit. The authorities planned to invest RMB 15 trillion in the transportation sector over the five-year period between 2016 and 2020, with highways accounting for over half of the investment, followed by railways (23%), air transportation (4.3%) and water transportation (3.3%). The table also shows our calculation of the realized investment amount in these four sub-sectors for the period of January 2016 to June 2019. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. Table I-1 suggests the remaining FAI for the transportation sector for the July 2019 to December 2020 period will be considerably smaller than the FAI amount over the past 18 months. This entails a major drag on infrastructure investment at least over the next 18 months. It is important to emphasize that this is conditional on the central planners in Beijing sticking to their five-year plan for infrastructure FAI. As of now, there has been no announcement of revisions to these five-year FAI targets. Bottom Line: China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. …And Real Terms Table I-2 summarizes the 2020 targets for major Chinese infrastructure development (urban rail transit, railway, highway and airport) in real terms. Chart I-10Transportation 2020 Targets: Not Far Away In real terms, the annual growth of transportation infrastructure will likely be 4.2% in both 2019 and 2020. We illustrated in the previous section that the five-year budget plan had been front-loaded, leaving a very small budget for transportation investment over the next 18 months. This may suggest that without considerably exceeding the budget, transportation infrastructure will fail to achieve the 4.2% annual growth in real terms both this year and next. In brief, more funding should be dispatched/allowed by the central planners in Beijing for infrastructure FAI not to shrink. Second, urban rail transit, high-speed railways, highways and airports will reach their respective 2020 targets, while non-high-speed railway construction will likely be a little bit off its 2020 target. Third, based on the 2020 targets, urban rail transit will enjoy very fast growth over the next one and a half years. Fourth, the growth of high-speed railways and highways will be very low, at around 1-2% in real terms (Chart I-10). Finally, while the number of airports will increase at a faster pace, their contribution to overall infrastructure investment will remain insignificant as they only account for about 1.4% of overall infrastructure investment. Bottom Line: In real terms, transport infrastructure growth will likely be only about 4% over the next six to nine months. Future Infrastructure Investment Focus Urban rail transit, environmental management and public utility management will likely be the major driving forces for Chinese infrastructure investment over the next 18 months. Urban rail transit line length will likely register fast growth of around 10% over the next six to nine months. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management will likely experience continued growth acceleration (Chart I-11). China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. Meanwhile, as the country’s urbanization continues and more townships and city suburbs become urbanized,5 public utility management investment will also grow moderately. Public utility management investment, contributing a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels in the city. Investment Implications Investors should not hold their breath expecting a major upswing in infrastructure FAI and a major rally in related financial markets. Chinese steel demand is sensitive to construction of railways and urban rail transit lines (Chart I-12, top panel). In turn, mainland cement demand is dependent on highway construction (Chart I-12, bottom panel). Chart I-11Environment Management: Will Continue Booming Chart I-12Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand...   Chart I-13...And Steel & Cement Prices At The Margin The infrastructure sector accounts for about 10-15% of total Chinese steel use, and about 30-40% of Chinese cement consumption. Nevertheless, given that we believe Chinese infrastructure spending will only have a moderate recovery, the positive effect on steel and cement prices will be muted as well (Chart I-13). The same holds true for spending on industrial machinery, equipment, chemicals and various materials. Notably, risks to this baseline scenario of a muted recovery are to the downside because of the lack of funding. Barring a substantial increase in the special bond issuance quota this year or a major credit binge, infrastructure FAI growth could in fact stall. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1  Please note that the central government only set the special bond balance limit (not the quota) for local governments. The often-cited “quota” in the news is derived by calculating the difference between the current limit and the previous year’s limit. The “quota” used in this report is the difference between the current special bond balance limit and the actual special bond balance of the previous year end. 2  At the end of 2018, Chinese special bond balance was RMB 7.4 trillion, only 85.8% of the special bond balance limit of RMB 8.6 trillion. This ratio was 84.6% in 2017 and 85.5% in 2016. On average, the ratio was 85.3% in the past three years. 3  Given that the central government is aiming to somewhat stimulate infrastructure spending by increasing special bond issuance, we assume special bond balance at the end of 2019 to reach 88%-90% of the limit (RMB 10.8 trillion) that it has set for 2019. This will be higher than the 85% average of the past three years. In turn, this means that the special bond balance at the end of this year will likely be RMB 9.5-9.7 trillion. Since the balance at the end of last year was RMB 7.4 trillion, this results that net special bond issuance will be around RMB 2.1-2.3 trillion in 2019. Given the net special bond issuance last year was RMB 1.7 trillion, it follows that there will only be a RMB 400-600 billion increase in total special bond issuance in 2019 versus 2018. 4  Please see www.gov.cn/xinwen/2017-02/28/content_5171576.htm, published February 28, 2017, by the Chinese central government website. 5  Please see Emerging Markets Strategy/China Investment Strategy Special Report “Industrialization-Driven Urbanization In China Is Losing Steam,” dated January 2, 2019, available on ems.bcaresearch.com