Asset Allocation

Dear Clients, This week we have an abbreviated Weekly Report followed by a Special Report penned by my colleagues Jeremie Peloso and Arseniy Urazov on the Fed’s “mid-cycle adjustment” and sector performance. I hope you will find this report insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights Portfolio Strategy The 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies. Recent Changes There are no changes to the portfolio this week. Table 1 Point Break Point Break Feature Chart 1Repricing To Lower EPS Backdrop Has Started Repricing To Lower EPS Backdrop Has Started Repricing To Lower EPS Backdrop Has Started The SPX took it to the chin last week, but managed to recover some of the losses by Friday’s close. It appears as though equity investors are slowly becoming thick skinned to President Trump’s tweets and instead starting to focus on softening earnings fundamentals. Last week we showed that SPX EPS are at stall speed, having a tough time surpassing the $165/share mark, eerily reminiscent of the 2014-16 episode when they hit a wall near $118/share.1 Importantly, sell-side analysts are trimming Q3/2019, Q4/2019 and calendar 2020 EPS estimates and investors need to be patient and wait out this shake out period that will be full of bearish undertones (Chart 1). U.S. Equity Strategy’s view remains cautious on a 3-12 month horizon on the prospects of the broad equity market, which stands in contrast to BCA’s sanguine cyclical equity market house view.   Another similarity with the 2015/2016 manufacturing recession episode is the Chinese renminbi devaluation on August 11, 2015 and subsequent parabolic move in the VIX above 50 on August 24, 2015. There are high odds that the SPX will succumb to the renminbi’s recent devaluation (Chart 2) and volatility will surge further in coming months as the trade war outcome is highly uncertain. Indeed, a number of internal equity market indicators suggest that the volatility spike has yet to run its course (Chart 3). Chart 2The Yuan To Watch The Yuan To Watch The Yuan To Watch Chart 3Vol Is Primed To Spike Vol Is Primed To Spike Vol Is Primed To Spike Beyond the heightened volatility, the brief 10/2 yield curve slope inversion last week was unnerving and a reason to remain cyclically cautious on the overall equity market outlook (Chart 4). As a reminder, the yield curve inversion signals additional Fed interest rate cuts and, historically, that has been a bearish backdrop for stocks as we highlighted in recent research (please see Chart 1 from the July 29th Weekly Report). In addition, the collapse in long term interest rates is cause for concern as it suggests that growth will be scarce in coming quarters. While stocks have been benefiting from lower interest rates via higher valuation multiples as theory would suggest, our sense is that a tipping point likely occurred last week. The implication is that stocks will likely heed the bearish message bonds are sending and converge to the steeply declining 10-year nominal and real yields (Chart 5).   Chart 4Another Bad Omen Another Bad Omen Another Bad Omen Chart 5Time To Get Back Together Time To Get Back Together Time To Get Back Together   Adding it up, the 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Insight Report, “Trump Backpedals, Again” dated August 14, 2019, available at uses.bcaresearch.com.

Highlights Disappointing economic data outside the U.S. and the inversion of the 2-year/10-year portion of the Treasury curve have overshadowed positive developments on the trade front. Global growth should improve later this year, spurred on by lower bond yields and fiscal stimulus in some countries. In contrast to the consensus view, we see flatter yield curves around the world as a “glass half full” story, mainly reflecting the shift to an ultra-dovish stance by most central banks. A variety of structural forces have dragged down term premia in fixed-income markets, thus making the purported recessionary signal from an inverted yield curve less prescient. Had the U.S. term premium in the mid-1990s been anywhere close to today’s levels, the yield curve would have surely inverted, causing yield curve-obsessed investors to miss out on the biggest equity bull market in history. The meltdown in bond yields is ending. Investors should favor stocks over bonds over the next 12-to-18 months. Feature Recession Risk Forces Trump’s Hand Risk assets remain caught in the crossfire of slowing global growth, flattening yield curves, and trade war uncertainty. Stocks received a short-lived boost on Tuesday from the Trump Administration’s decision to delay raising tariffs until December 15th on roughly 60% of the Chinese imports – including smartphones, laptops, and toys – which were slated to be taxed starting September 1st. The decision followed a phone call between U.S. and Chinese trade representatives that Trump described as “very productive.” Seemingly in contradiction to his earlier claim that China will end up bearing the full cost of the tariffs, President Trump admitted that “We're doing this for the Christmas season, just in case some of the tariffs would have an impact on U.S. customers.” The fact that the trade war is weighing on growth and the stock market has not been lost on Trump. The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that 34% of managers believed that a recession is likely within the next 12 months. This is the largest share in eight years. The trade war topped the list of “biggest tail risks” for the fifth month in a row. A net 22% of investors said they had taken out protection against a sharp drop in the stock market, the highest number since the survey began asking this question in 2008. The question is whether Trump’s half-hearted attempt to hold out an olive branch to the Chinese is too little, too late. The fact that the Chinese government indicated on Thursday that it will still go ahead and take “necessary countermeasures” suggests that Trump’s overture does not go far enough. More worryingly, the meltdown in bond yields and the stock market’s failure to hold Tuesday’s gains imply that many investors think that the trade war has already pushed the global economy past the breaking point. Industrial Activity Struggling To Find A Bottom It is not helping matters that industrial activity outside the U.S. remains in a slump. It was confirmed this week that the German economy contracted in the second quarter on the back of flagging export demand. The decline in the expectations component of the German ZEW survey in August to the lowest level since 2012 suggests that growth has remained weak in the third quarter. Chinese economic activity also disappointed in July. Industrial production growth slowed significantly. Retail sales decelerated, led by a relapse in automobile sales. A variety of political developments around the world have further undermined market confidence. The protests in Hong Kong have become increasingly violent, causing severe disruptions to air travel in the region. The risks of a hard Brexit are rising. Italy’s coalition government has collapsed. And in one of the biggest daily moves on record, the Argentine stock market fell by 48% in dollar terms on Monday after its current reform-minded president, Mauricio Macri, was trounced by his left-wing rival in primary elections. Will The U.S. Be Dragged Down? The U.S. economy has held up relatively well compared with the rest of the world. Retail sales rose by 0.7% in July, the fastest pace in four months, and more than twice what analysts were expecting. While industrial production was somewhat softer than expected, both the Philly and New York Fed manufacturing surveys surprised on the upside. The forward-looking new orders component increased in both surveys. With this week’s data in hand, the Atlanta Fed’s GDPNow model is forecasting that U.S. real GDP will rise by 2.2% in Q3. Real final domestic demand, which excludes the contribution from net exports and inventories, is set to grow by an even-healthier 3% (Chart 1). Chart 1 Given the still reasonably firm U.S. data, why are so many pundits and market participants fretting about a recession? One key reason is that the yield curve has inverted. An inverted yield curve has historically been a reliable predictor of recessions (Chart 2). Chart 2The U.S. Yield Curve: Still Prescient? The U.S. Yield Curve: Still Prescient? The U.S. Yield Curve: Still Prescient? Yield Curve Angst President Trump wasted little time on Wednesday sarcastically thanking “clueless” Jay Powell and the Federal Reserve for the “CRAZY INVERTED YIELD CURVE” (emphasis his). Trump and the investment community should relax a bit. In contrast to the consensus view, we see flatter yield curves around the world as a “glass half full” story, mainly reflecting the shift to an ultra-dovish stance by most central banks. Not only has the Fed turned more dovish, but other central banks have cranked up monetary stimulus. A Wall Street Journal story published earlier today quoted Olli Rehn, the current governor of the Finnish central bank and member of the ECB’s rate-setting committee, as saying that the ECB is looking to unveil a “significant and impactful policy package” in September, adding that “When you’re working with financial markets, it’s often better to overshoot than undershoot.”1 Since short-term rates in the euro area and in a number of other countries cannot fall much from current levels, the only way for the ECB to ease financial conditions is to signal that short-term rates will stay lower for longer and to buy up long-term bonds through large-scale asset purchase programs. This naturally leads to lower bond yields and flatter yield curves. Falling bond yields in Europe and around the world have, in turn, dragged down U.S. yields. Unlike in the past, term premia are negative across the major economies. This means that investors today can expect to earn more by rolling over a short-term government security than by buying a long-term government bond. In addition to central bank asset purchases, rising demand for bonds from institutional investors has depressed term premia. Desperate to match their long-duration liabilities with equally long-duration assets, insurance companies and pension funds have been forced to purchase bonds with low (and sometimes even negative) yields. Term premia have also come down as investors have grown accustomed to seeing bonds as a good hedge against equity risk in particular, and recession risk in general (Chart 3). Chart 3Owning Long-Term Bonds Is A Good Hedge Against Equity Risk Owning Long-Term Bonds Is A Good Hedge Against Equity Risk Owning Long-Term Bonds Is A Good Hedge Against Equity Risk As such, one should take the purported recessionary signal from an inverted yield curve with a grain of salt. Today, the U.S. 10-year term premium stands at -1.2%. In late 1994, when the yield curve almost inverted, the term premium was 1.9%. Had the U.S. term premium in the mid-1990s been anywhere close to present levels, the yield curve would have surely inverted, causing yield curve-obsessed investors to miss out on the biggest equity bull market in history. TINA’s Siren Song For investors, the collapse in bond yields increasingly means that There Is No Alternative to equities. We will have much more to say about “TINA” in a forthcoming special report; but for now, suffice it to say that ultra-low bond yields have improved the relative attractiveness of stocks. The S&P 500 dividend yield is currently 2.03%, 51 bps above the yield on 10-year Treasury notes (Chart 4). To put things in perspective, even if S&P 500 companies did not increase cash dividends at all for the next ten years, the real value of the index would still have to fall by 28% (assuming 2% inflation) for bonds to outperform stocks. Chart 4S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield All this means that global growth is probably close to a bottom. This, in turn, implies that the meltdown in bond yields is likely to end soon. Investors should favor stocks over bonds over the next 12-to-18 months. Chart 5 shows that the equity risk premium in the U.S. remains well above its historic norm. The equity risk premium is even higher outside the U.S., reflecting both the fact that valuations are cheaper abroad and that interest rates are generally lower. Chart 5AEquity Risk Premia Remain Well Above Their Historic Norms (I) Equity Risk Premia Remain Well Above Their Historic Norms(I) Equity Risk Premia Remain Well Above Their Historic Norms(I) Chart 5BEquity Risk Premia Remain Well Above Their Historic Norms (II) Equity Risk Premia Remain Well Above Their Historic Norms(II) Equity Risk Premia Remain Well Above Their Historic Norms(II) It is useful to contrast today’s high equity risk premia with the fact that global cash allocations in the latest BofA Merrill Lynch survey stood at 5.1% in August (1.5 standard deviations above their long-term average). Bond allocations were also 1.1 standard deviations above their long-term average. On the flipside, asset allocators were net 12% underweight stocks (1.7 standard deviations below their long-term average). In fact, aside from June of this year, this represents the biggest equity underweight since March 2009. Given this backdrop, stocks are likely to continue to climb the proverbial wall of worry. Investment Conclusions We argued in our August 2nd report that risk assets are likely to face some near-term pressure.2  That pressure has been realized. At this point, we would not be chasing stocks lower. Yes, global growth, at least outside the U.S., remains weak. Encouragingly, however, the slowdown has been largely confined to the manufacturing sector. Unlike in 2008, the service sector has remained fairly resilient (Chart  6). Even in Germany, the service PMI has actually risen since late last year. Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) Global manufacturing cycles tend to last three years – 18 months up, 18 months down (Chart 7). The last downleg began in early 2018. Provided the trade war does not spiral out of control, we are due for another upturn in manufacturing activity. Chart 7The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Chart 8Looser Fiscal Policy In The Euro Area Looser Fiscal Policy In The Euro Area Looser Fiscal Policy In The Euro Area   A bit more fiscal stimulus should help. Chinese credit growth came in much weaker-than-expected in July. With growth still soggy there, we expect the Chinese authorities to redouble stimulus efforts over the coming months. Fiscal policy in the euro area is also being loosened (Chart 8). Further easing is likely in Germany, where support for a German version of a “Green New Deal” is gaining traction.  All this means that global growth is probably close to a bottom. This, in turn, implies that the meltdown in bond yields is likely to end soon. Investors should favor stocks over bonds over the next 12-to-18 months. We expect to upgrade EM and European equities during the next few months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     1      Tom Fairless, “ECB Has Big Bazooka Primed for September, Top Official Says,” The Wall Street Journal, August 15, 2019. 2      Please see Global Investment Strategy Weekly Report, “A One-Two Punch,” dated August 2, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 9 Tactical Trades Strategic Recommendations Closed Trades

Highlights The failure of the dollar to break out amid one of the most bullish fundamental catalysts in months suggests that many opposing tectonic forces are at play. Our bias is that short-term and longer-term investors are caught in a tug-of-war. Longer-term headwinds are a deteriorating balance-of-payment backdrop. Shorter-term tailwinds are ebbing global growth. Traders who have become accustomed to buying the dollar as a safe haven should be cognizant that correlations could be shifting amid the fall in global bond yields. The yen and gold remain the currencies of choice in this environment. Despite economic headwinds, the BoJ has historically needed an external shock to act, suggesting the path towards additional stimulus will be lined with a stronger yen. Our bias is that USD/JPY could weaken to 100 in the next three-to-six months, especially if market volatility spikes further. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. The reversal in the EUR/GBP is worth monitoring. Aggressive investors can short the pair now for a trade. Feature Chart I-1A Worrisome Development A Worrisome Development A Worrisome Development Consider the events over the last few weeks: U.S. President Donald Trump blindsided investors by firing a new salvo in the trade war. China retaliated by depreciating the RMB below the psychologically important 7 level. In Argentina, a heavy loss for reformist Mauricio Macri has sent the peso down almost 40% this year. Venezuela is now completely shut off from the U.S., given continued friction between the regime of incumbent Nicolás Maduro and Juan Guaidó. In Europe, Boris Johnson has all but assured us that he is taking the U.K. out of the EU, sending the pound to near post-referendum lows. And on the global economic front, July manufacturing data was dismal across the board. This is nudging the U.S. 10-year versus 2-year Treasury yield curve into inversion, adding to the recessionary indicators that have accumulated so far (Chart I-1). Both gold and the yen have bounced in sympathy with these developments, but the trade-weighted dollar (either using the DXY or the Federal Reserve’s broader measure) is up only circa 1% over the last month. Had a currency manager taken a one-month leave of absence, this setup would be incredibly perplexing upon return. Has the investment landscape changed, or are both traders and algorithmic platforms sitting on the sidelines given thin summer trading? More importantly, has the dollar lost its crown as a safe-haven currency? The answers to these questions are obviously very important for the cyclical view on the dollar.  Is This Time Different? It is too early to tell if the dollar’s muted response is just the lagged effect of thin summer trading, or a signal towards much bigger opposing forces at play. What we can infer is that both short-term and longer-term investors are caught in a tug-of-war, currently in a stalemate. The short-term boost for the dollar comes from the fact that global growth is weak and the U.S. economy has the upper hand, given the smaller contribution from the manufacturing sector to GDP. Meanwhile, U.S. interest rates, while falling, remain among the most attractive in the developed world. Portfolio flows into the U.S. economy is the ultimate link between global growth and the dollar. The caveat is that these bullish factors are slowly ebbing. We have argued in past reports that global growth will soon bottom, if past correlations between monetary stimulus and economic growth hold. Meanwhile, the Federal Reserve is slated to become more dovish, which will remove an important tailwind for the dollar (Chart I-2). The latest comments from Olli Rehn, governor of the Finnish central bank and member of the ECB’s rate-setting committee, suggests that significant stimulus will be forthcoming in September. This should keep a bid under the DXY index. However, investors also understand that other governments are unlikely to sit pat and watch their trading partners wage a currency war. Political pressure towards lower rates is now as high as it has ever been (Chart I-3), a change from the past. Chart I-2The U.S. Yield Advantage Is Fading The U.S. Yield Advantage Is Fading The U.S. Yield Advantage Is Fading Chart I-3Political Pressure To Cut Rates Political Pressure To Cut Rates Political Pressure To Cut Rates But why has the dollar not strengthened more in the interim, given that bullish forces remain present? The answer lies in underlying portfolio flows into the U.S. economy, which is the ultimate link between global growth and the dollar. Everyone understands the standard feedback loop between global growth and the greenback. The U.S., being a relatively closed economy, sees outflows when global growth is improving. This is because capital tends to gravitate to higher-yielding currencies that are more levered to the manufacturing cycle. And during risk-off environments, that capital finds its way back home – the so-called “home-bias” – that boosts the dollar. This has been the story for most of the last two decades. However, things began to shift a few years ago. Following cascading crises (in Europe, Japan and even some commodity-producing countries, for example), interest rates outside the U.S. began to fall rapidly, and the U.S. bond market became one of the most attractive in yield terms. For example, at the onset of 2014, 10-year bond yields were at 4.4% in Australia while they were sitting at 3% in the U.S. Today, a 10-year Australian bond yields 0.9% while 10-year Treasurys are at 1.5%. The implication is that the U.S. dollar has now become an object of carry trades itself, as confirmed by current positioning data (Chart I-4). However, here comes the important crux. It is difficult for the dollar to act as both a safe-haven and a carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding, but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given that U.S. investors have already been repatriating close to $300 billion in assets over the past 12 months (in part because of better returns, but also because of the 2017 Trump tax cuts), the dollar’s safe-haven bid has partially evaporated. Traders who have been used to buying the dollar as a safe haven should be cognizant that correlations may have shifted amid the fall in global bond yields.  Flows into the U.S. capital markets are instructive. What has been supporting capital flows into the U.S. are agency, corporate, and Treasury bond purchases, with foreign investors already stampeding out of U.S. equities at the fastest pace on record (Chart I-5). This is because 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. Chart I-4 Chart I-5Banks Have Been Supporting U.S. Inflows Banks Have Been Supporting U.S. Inflows Banks Have Been Supporting U.S. Inflows Meanwhile, cracks are beginning to appear in the Treasury market, one of the last pillars of support for U.S. inflows. Foreign officials have already been exiting the U.S. bond market for both geopolitical and balance-of-payment concerns, but private purchases still remain robust. However, the latest data shows that net foreign private purchases of U.S. Treasury bonds have rolled over from about $220 billion dollars earlier this year to about $200 billion currently. Ebbs and flows in the U.S. Treasury market have historically had a great track record of capturing major turning points in the U.S. bond yields over the last decade (Chart I-6). To be sure, these flows are still positive, with June data robust, but they are rolling over. It is likely that July and August data will be stronger, given the drop in yields. However, long Treasurys and long dollar positions are some of the most crowded trades today. The bottom line is that if the dollar cannot rise under a bullish near-term backdrop, it is likely to fall hard when these fundamental forces evaporate. Monitoring the bond-to-gold ratio is a good way to gauge where the balance of forces are shifting, and the picture is not constructive for dollar bulls (Chart I-7). Meanwhile, currencies such as the Japanese yen or even the Swiss franc, which have been used to fund carry trades, remain ripe for further short-covering flows. Chart I-6What Happens When Bond Investors Flee? What Happens When Bond Investors Flee? What Happens When Bond Investors Flee? Chart I-7Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Bottom Line: Traders who have been used to buying the dollar as a safe haven should be cognizant that correlations may have shifted amid the fall in global bond yields. Stay Short USD/JPY Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Economic data from Japan over the past few weeks suggests the economy is not yet succumbing to pressures of weak external growth (Chart I-8). The services PMI remains relatively high compared to manufacturing, vehicles sales are accelerating at a 7% year-on-year pace and bank lending is still robust. The labor market also remains relatively tight, with Tokyo office vacancies hitting post-crisis lows. The preliminary print of second quarter GDP growth slowed to 1.8% from 2.2%, but this was entirely driven by the external sector. A return towards deflationary pressures will eventually force the Bank of Japan’s hand, but the yen will strengthen in the interim. What these developments suggest is that the hurdle for delaying the consumption tax is now extremely high. And since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. A return towards deflationary pressures will eventually force the Bank of Japan’s hand, but the yen will strengthen in the interim. This is because the BoJ will need to come up with even more unconventional policies, something that requires time. Total annual asset purchases by the BoJ are currently running at about ¥22 trillion, while JGBs purchases are running below ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon, since JGB yields are trading near the floor of the central bank’s range (Chart I-9). Chart I-8Japan Is Fine For Now Japan Is Fine For Now Japan Is Fine For Now Chart I-9The BoJ Is Out Of Bullets The BoJ Is Out Of Bullets The BoJ Is Out Of Bullets It is important to remember why deflation is so pervasive in Japan, making the BoJ’s target of 2% a bit of a pipedream if it stands pat. The overarching theme for prices in Japan is a rapidly falling (and rapidly ageing) population, leading to deficient demand (Chart I-10). Meanwhile, domestically, an aging population (that tends to be the growing voting base), prefers falling prices. What is needed is to convince the younger generation to save less and consume more, but that is almost impossible when high debt levels lead to insecurity about the social safety net. Hence the reason for the consumption tax, which has historically been deflationary. Chart I-10Deflation Is Pervasive In Japan Deflation Is Pervasive In Japan Deflation Is Pervasive In Japan On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-11). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. This suggests the shock needed for either the BoJ or the government to act has to be “Lehman” like.  The eventual bottom in global growth is a key risk to a long yen position. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital. The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds but has been weakening in recent years. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness (Chart I-12). Chart I-11Japan: More Easing Will Kill Banks Japan: More Easing Will Kill Banks Japan: More Easing Will Kill Banks Chart I-12The Nikkei And Yen Have Diverged The Nikkei And Yen Have Diverged The Nikkei And Yen Have Diverged Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it may first require a riot point (Chart I-13). Remain short USD/JPY. Chart I-13What More Could The BoJ Do? What More Could The BoJ Do? What More Could The BoJ Do? Housekeeping Chart I-14Look To Sell EUR/GBP Look To Sell EUR/GBP Look To Sell EUR/GBP Tactical investors could try selling EUR/GBP for a trade ahead of our actual limit-sell at 0.95. The ever-shifting political landscape warrants tight stops, but despite all the noise, economic surprises in the euro area are rolling over relative to the U.K., which usually benefits the pound (Chart I-14). Finally, the Norges bank has chosen to remain on hold, though has begun to sound less hawkish. We remain long NOK/SEK but are ready to take profits on any sign a currency war is intensifying, or that oil prices are headed much lower.     Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been robust: Headline and core inflation both edged up 10 bps to 1.8% and 2.2% year-on-year respectively in July. Mortgage applications surged by 21.7%, reversing prior weakness in the MBA Purchase Index. NY Empire State manufacturing index increased to 4.8 in August; The Philly Fed manufacturing index fell to 16.8, still well above the consensus of 9.5. Retail sales jumped by 0.7% month-on-month in July, up from downwardly-revised 0.3% in June. Nonfarm productivity grew by 2.3% quarter-on-quarter in Q2; The unit labor costs went up 2.4% quarter-on-quarter. Real hourly earnings in July however, slowed to 1.3% year-on-year. Industrial production fell by 0.2% month-on-month in July. DXY index appreciated by 0.6% this week. Consumer prices rebounded in July, mostly driven by shelter, and medical care services. This marginally lowered the prospect for more aggressive rate cuts by the Federal Reserve. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area continue to deteriorate: ZEW sentiment fell to -43.6 in August, the lowest since 2012. Preliminary GDP yearly growth was flat at 1.1% year-on-year in Q2, even though the German economy stagnated. Industrial production contracted by 2.6% year-on-year in June. Employment growth slowed to 1.1% year-on-year in Q2. EUR/USD fell by 0.9%, following the relatively soft data. However, if the world economy avoids recession, it will be tough for data to deteriorate meaningfully from current levels. We believe that manufacturing data will get a boost once global growth stabilizes. Meanwhile, the euro is currently trading at an attractive discount to its fair value. 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 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Producer prices contracted by 0.6% year-on-year in July. Core machinery orders increased by 12.5% year-on-year in June, while preliminary machine tool orders for July fell by 33% year-on-year, from -38% the prior month. Industrial production contracted by 3.8% year-on-year in June. Capacity utilization fell by 2.6% year-on-year in June. USD/JPY appreciated by 0.3% this week. Japanese data was notable healthier in June, suggesting that weakness in July was exacerbated by external factors. That said, long yen bets are in an enviable “heads I win, tails I do not lose too much” position, as posited in the front section of this bulletin. 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 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was a flurry of data out of the U.K. this week, most of which were firm: Preliminary GDP growth fell to 1.2% year-on-year in Q2, from the previous 1.8%.  This was mostly driven by investment that contracted by 1.6%. This makes sense given Brexit uncertainties. Exports contracted by 3.3% quarter-on-quarter in Q2, but imports fell 12.9% quarter-on-quarter. The total trade balance increased to £1.78 billion in June. The unemployment rate nudged up to 3.9% in June, but the labor report was robust. Weekly earnings soared by 3.9%. Headline and core inflation moved up to 2.1% and 1.9% year-on-year respectively in July. Lastly, total retail sales increased by 3.3% year-on-year in July. GBP/USD has been flat this week. While GDP data was clearly negative, the drop in the pound is clearly improving the balance of payments backdrop for the U.K. Our bias is that the pound could soon rebound once the Brexit chaos settles. Short EUR/GBP at 0.95. 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 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: NAB business confidence edged up to 4 in July, from 2. Westpac consumer confidence also rebounded by 3.6% month-on-month in August. Consumer inflation expectations increased to 3.5% in August. The employment report was robust. The unemployment rate was unchanged at 5.2% in July; 34.5 thousand full-time jobs and 6.7 thousand part-time jobs were created; Participation rate was little changed at 66.1%. Wages remained at 2.3% year-on-year in Q2. AUD/USD fell by 0.4% this week. The Aussie is a very ripe candidate for mean reversion, once the appropriate catalysts fall in place.  Net speculative positions on the Aussie dollar are very close to a bearish nadir. We continue to favor the Aussie dollar from a contrarian perspective. 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 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There is scant data from New Zealand this week: Net migration to New Zealand fell to 3100 in June. House sales increased by 3.7% year-on-year in July. NZD/USD fell by 0.5% this week. We remain bearish on the kiwi due to decreasing net migration, and falling terms-of-trade. Remain long AUD/NZD as a strategic holding. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Housing starts came in at 222K in July from 246K. Building permits decreased by 3.7% month-on-month in June; Existing home sales increased by 3.5% month-on-month in July. The labor report was poor. Unemployment increased to 5.7% in July. 11.6 thousand full-time jobs and 12.6 part-time jobs were lost in the month of July. Average hourly wages however, soared by 4.5% year-on-year in July, from the previous 3.6%. Bloomberg nanos confidence index fell to 57.8 over the past week. USD/CAD increased by 0.7% this week. A combination of robust wage growth, accommodative fiscal policy, and low interest rates, has supported the Canadian housing market in the summer. Moreover, energy prices should hook up which will benefit CAD. We remain positive on the loonie in the near-term. 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 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Unemployment rate was stable at 2.3% in July. Producer and import prices contracted by 1.7% year-on-year in July. USD/CHF has been flat this week. The terms-of-trade in Switzerland soared to 128 in June from the previous 117 in May. We continue to favor the franc due to a positive current account, and its safe-haven allure. 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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mostly positive: Headline inflation was stable at 1.9% year-on-year in July, while core inflation fell slightly to 2.2% year-on-year in July. Producer prices contracted by 8.6% year-on-year in July. The trade balance widened to NOK 6.5 billion in July. USD/NOK increased by 1% this week. The Norges Bank kept interest rates unchanged yesterday at 1.25%, and said the policy outlook has become more uncertain amid rising global risks. The central bank guidance had been irrefutably hawkish prior to yesterday. The current dovish shift reflects more uncertainties in the global market and energy prices. Remain long NOK/SEK for now, while earning a positive carry. 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 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption decreased by 0.3% year-on-year in June. Unemployment rate nudged up to 6.3% in July. Headline and core inflation both fell to 1.7% year-on-year in July. USD/SEK increased by 0.5% this week. The July inflation has been the lowest since early last year, mostly due to a slowdown in the prices of transport, recreation and culture, and durable goods. That said, disinflation is now a global phenomenon. We remain long SEK/NZD as a relative value trade. 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 A lot has changed in a week and a half, … : The FOMC meeting that we thought would mark the end of global market-moving news until September turned out to be a prelude for the real fireworks. … as U.S.-China trade tensions escalated, … : The imposition of tariffs on the only remaining subset of Chinese imports that had escaped duties so far inspired China to let the yuan fall below a key technical level. … and other countries braced for the fallout: China’s devaluation opened up a new front in the conflict, turning a bilateral tariff spat into a threat to other countries’ well-being and competitiveness. Asia-Pacific central banks swiftly followed with larger-than-expected rate cuts. Below-benchmark-duration positioning is no longer appropriate in the near term, and we recommend moving to benchmark duration: Interest rates will be hard-pressed to rise with global central banks squarely in easing mode. Although we still believe that inflation and the fed funds rate will surprise to the upside, it’s going to take a while. Feature Dear Client, There will be no U.S. Investment Strategy next week as we take our final summer break. U.S. Investment Strategy will return on Monday, August 26th. Best regards, Doug Peta So much for the idea that the July 30-31 FOMC meeting would be the last market-moving event before Labor Day. By lunchtime on August 1st, the S&P 500 was back to its July 30th close above 3,010; the 10-year Treasury yield had settled around 1.96%, ten basis points (“bps”) lower than its pre-meeting level; and gold had fallen by ten bucks, to $1,420, as markets digested the news that the Fed was less concerned about the economy than they were. Then the trade war reared its ugly head in the form of new tariffs on Chinese imports to the U.S., and the S&P slid to 2,822, the 10-year Treasury yield tumbled to 1.59%, and gold surged to $1,510. The new round would ensnare the subset of goods that had previously been spared from import duties, and Beijing promised to retaliate. It’s hard for rates to rise when every central bank has an easing bias as it nervously eyes the U.S.-China tilt.   Chart 1Beijing Plays The Currency Card Beijing Plays The Currency Card Beijing Plays The Currency Card The retaliation arrived Sunday night in the U.S., when Chinese officials allowed the renminbi to trade above 7 to the dollar for the first time since 2008 (Chart 1). The move provoked a global equity selloff, and the S&P 500 lost 3% in its worst session of the year. With the currency floodgates opened, the trade war morphed from a bilateral tariff spat into a global battle for competitiveness, and central banks in India, Thailand and New Zealand responded with larger-than-expected rate cuts. India is a comparatively closed economy battling a domestic downturn, but it is clear that countries with any reliance on exports are loath to be saddled with a strong currency that will hamstring their global competitiveness. It turns out that the Fed isn’t the only central bank that sees the appeal of taking out some insurance. That is an unfriendly backdrop for below-benchmark-duration positioning, and we are joining our fixed-income colleagues in raising our duration recommendation from underweight to neutral over the tactical timeframe (0-3 months). While we still believe that the fed funds rate and long yields will surprise to the upside, they cannot do so while bond investors are adamant that the Fed is going to have to adopt an easing bias over the near term. Our rates checklist, discussed in the rest of this report, supports the decision. The shift in the rates backdrop undermines our newly established agency mortgage REIT recommendation, and we are watching it closely. The Rates Checklist: The Fed Table 1Rates View Checklist When The Facts Change When The Facts Change Turning to our rates view checklist (Table 1), the first item is derived from our U.S. Bond Strategy service’s golden rule of bond investing.1 The golden rule asks one simple question to anchor views on Treasuries: Over the next 12 months, will the Fed move the fed funds rate by more or less than the bond market is currently discounting? Since 1990, when the Fed has surprised dovishly (the fed funds rate has turned out to be lower than the money market implied twelve months earlier), Treasuries have almost always generated positive excess returns over cash. Periods of negative excess returns have occurred nearly exclusively when the Fed has delivered a hawkish surprise. We still think inflation will become a problem, but it certainly isn’t one yet. Since we rolled out the checklist last year, we have consistently expected a hawkish surprise. Though we continue to believe that an extended cycle of rate cuts is not in the cards, markets disagree, and we concede that the Fed now has a near-term easing bias, despite Chair Powell’s demurrals at the post-meeting press conference. We are leaving the box unchecked because we believe that nearly four more 25-bps cuts over the next twelve months, equating to a target fed funds rate of 1.25-1.50% (Chart 2), are unlikely. The spread between our expectations and the market’s expectations is still wide enough to merit a below-benchmark-duration view over the next twelve months, even if benchmark duration makes more sense for the rest of the year. Chart 2Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch The yield curve’s inversion has become more pronounced in the wake of the re-escalation of the trade war (Chart 3), and we duly check the second box. As a reminder, we track the 3-month/10-year segment of the yield curve to define inversion because it is less susceptible to estimate error, and has been a timelier indicator of recessions, than the more frequently cited 2-year/10-year segment. We have argued before that the unprecedentedly large negative 10-year term premium makes the curve more prone to invert and makes it a less sensitive economic barometer, but part of the rationale of creating a checklist is to limit one’s discretion in interpreting events. Chart 3More Rate Cuts, Please More Rate Cuts, Please More Rate Cuts, Please The Rates Checklist: Inflation Inflation has gone AWOL around the globe. Although the U.S. no longer faces the negative output gaps that remain in other major economies, its main measures of consumer prices (Chart 4) do nothing to counteract the widespread view that the Fed has a free pass to devote its energies to shoring up growth. Inflation break-evens were making progress toward the 2.3-2.5% range consistent with the Fed’s 2% inflation target when we launched the checklist last year, but the plunge in oil prices stopped them in their tracks (Chart 5). Rather than encouraging the Fed to hike, soft inflation expectations helped drive the Fed’s dovish pivot. Chart 4Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Chart 5... And So Are Inflation Expectations ... And So Are Inflation Expectations ... And So Are Inflation Expectations Our view that the seeds of inflation pressures have been sown has not changed. After slowing on a real final domestic demand basis in the first quarter from the one-two punch of the government shutdown and the fourth quarter’s sharp tightening of financial conditions, the U.S. economy has resumed operating above capacity. Though we check the “sluggish-inflation” boxes, and acknowledge that inflation is not going to inspire a more restrictive turn in Fed policy any time soon, we do think it will become an issue down the road. The Rates Checklist: The Labor Market The labor market remains robust. The headline unemployment rate remains at a level last seen in 1969, and is well below the CBO’s estimate of NAIRU. NAIRU is the minimum structural unemployment rate, and wage gains quicken when the unemployment rate falls below it (Chart 6). The broader definition of unemployment, encompassing discouraged workers and involuntary part-time workers, fell to its lowest level since 2000 in July (Chart 7), and the job openings and job quits rates (Chart 8) indicate that demand for workers remains high. Chart 6Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Chart 7... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust ... And Demand Is Robust ... And Demand Is Robust Chart 9   3.2% year-over-year growth in average hourly earnings may not be thrilling, but wages do remain in an uptrend. The laws of supply and demand (Chart 9), and the Fed’s best efforts, suggest that the uptrend will continue. We do not check any of the labor market boxes, and expect that we will not over the rest of the year. The Rates Checklist: Instability At Home And Abroad Chart 10No Overheating Yet No Overheating Yet No Overheating Yet There continue to be no signs of cyclical overheating in the U.S. economy, as the most cyclical segments of the economy are nowhere near the red end of the tachometer (Chart 10). Financial imbalances have moved to the back burner, but they are part of the Fed’s post-crisis mandate, and we are leaving the imbalances box unticked to reflect that the “low spreads and loosening credit terms” Governor Brainard decried last September2 may stay the Fed from embarking on a full-on easing cycle. We are checking the international duress box, at least for the time being, given the potential for a self-reinforcing rate-cutting cycle that could hold down the entire term structure of rates around the world. Bottom Line: The inverted yield curve, a lack of consumer price inflation, and the cloud cast by the trade war all suggest that bond markets will require some convincing before they allow rates to rise much higher. We conclude that a neutral duration stance is appropriate in the near term. Keeping Score We have been staunch supporters of below-benchmark duration positioning since the end of last July,3 given that we thought the 10-year Treasury yield was too low relative to our assessment of the strength of the U.S. economy and the potential for inflation to begin to rise. It appears that our stronger-than-consensus economic view was correct, but we were myopic in failing to grasp how punk growth in the rest of the world would keep long-maturity Treasury yields from making a sustained move higher. We were way early on inflation’s ETA, and slow to grasp how sensitive the Fed would be to faltering global growth and escalating trade tensions in its absence. In short, both our model of the Fed’s reaction function and the inputs to our model turned out to be faulty. The duration call stings, but our asset allocation recommendations have worked out. The fix we are making is to wait until inflation is a clear and present danger before assuming that the Fed will respond to it. Although we got the duration call wrong, investment-grade and high-yield corporate bonds have outperformed Treasuries in the aggregate since we upgraded them to overweight versus Treasuries at the end of January (Chart 11). BCA as a house niftily sidestepped the fourth-quarter selloff in equities by downgrading them to equal weight, and raising cash to overweight, late last June. We upgraded equities to overweight versus cash and fixed income in our first publication of the year, and the S&P 500 has handily outperformed Treasuries since that date, despite the nasty selloff following the July FOMC meeting and the new round of tariffs (Chart 12). Chart 11Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Chart 12... But Equities Have Crushed Them ... But Equities Have Crushed Them ... But Equities Have Crushed Them Agency Mortgage REIT Implications We recommended agency mortgage REITs a day before the FOMC meeting, suggesting that investors allocate capital away from equities and high yield as a way to reduce equity beta and boost portfolio income away from the herd chasing lower and lower high-yield bond yields. Through Thursday’s close, the Bloomberg Mortgage REIT Index has gained about 35 bps on a total return basis, while the Barclays High Yield Index is off 70 bps and the S&P 500 is down 2.7%. Unfortunately, the agency mREITs we sought out for their yield curve exposure have lagged badly as the yield curve has relentlessly flattened. For now, only the one agency mREIT with a dedicated adjustable-rate mortgage portfolio faces immediate earnings pressure. The rest are subject to refinancing volumes, which are likely to be higher than we expected when we projected that the 10-year Treasury yield wouldn’t fall much below 2%. The specter of increased prepayments makes the agency mREITs a less attractive investment than we thought they would be two weeks ago. On the other hand, their exclusively domestic exposure, and low credit risk, increases their value as a haven from global turmoil. Net-net, we are sticking with them, though they are now on a far shorter leash than they were when we made the recommendation. We will not stick with a position to save face, or to avoid looking irresolute. Flexibility and a willingness to admit mistakes are essential characteristics of successful investors. When the facts change, we change our mind, without the faintest hint of embarrassment. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 24, 2018 U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” available at usbs.bcaresearch.com. 2 Brainard, Lael (2018). “What Do We Mean by Neutral And What Role Does It Play in Monetary Policy,” speech delivered at the Detroit Economic Club, Detroit, Mich., September 12, 2018. 3 Please see the July 30, 2018 U.S. Investment Strategy Weekly Report, “The Rates Outlook,” available at usis.bcaresearch.com.

Just as it appeared the slowdown in global industrial activity had run its course, commodity markets face another test of demand resiliency brought on by exogenous political shocks (Chart Of The Week). As luck would have it, these shocks – arriving in the form of an unexpected escalation of Sino-U.S. trade tensions – came on the heels of reports of further weakness in global manufacturing activity, a less-dovish-than-expected Fed, and a breach of the 7.0 level of the RMB/USD cross. The fallout – a global risk-off event – raises the spectre of a deeper trade war damaging EM GDP growth, which would weaken commodity demand. We continue to expect global fiscal and monetary stimulus to revive commodity demand, albeit further out the curve – i.e., later this year, as opposed to earlier in 2H19. Given the trade-war escalation, we are recommending a tactical long position in spot silver to hedge portfolio risk. The metal has been tracking gold’s ups and downs post-GFC – more so than industrial demand for silver – indicating it may have some catching up to do. This will make us strategically long gold, and tactically long silver at tonight’s close. Chart Of The WeekRenewed Trade Tensions Threaten Industrial Commodities' Recovery Renewed Trade Tensions Threaten Industrial Commodities' Recovery Renewed Trade Tensions Threaten Industrial Commodities' Recovery   Highlights Energy: Overweight. U.S. President Trump informed Congress earlier this week he was imposing a total economic embargo on Venezuela, which freezes assets of the Maduro government and all business dealings with its representatives except for humanitarian aid. Venezuela’s oil production averaged ~ 750k b/d in 2Q19, and was supported by the assistance of Russian technicians, U.S.-based Chevron Corp., and four service companies that were granted 90-day waivers by the U.S. to continue to do business in the country.1 Our long Sept19 Brent vs. short Sept20 Brent position expired with a gain of 101.7%. We remain long 4Q19 Brent vs. short 4Q20 Brent. Base Metals: Neutral. Industrial metals, iron ore and steel came under renewed selling pressure this week, in the wake of heightened trade tensions between the U.S. and China. Precious Metals: Neutral. Safe-haven demand rallied gold 3% over the week ended Tuesday, following the escalation in Sino-U.S. trade tensions. We continue to favor gold as a strategic portfolio hedge, particularly if central banks are compelled to accelerate monetary accommodation as global trade tensions rise, and are adding a tactical long silver position to our recommendations. Ags/Softs: Underweight. China’s Commerce Ministry reported U.S. ag products no longer are being purchased by Chinese companies earlier this week.2 U.S. President Trump’s decision to impose tariffs on Chinese imports to the U.S. were occasioned by his claim China was not living up to an agreement to increase agricultural purchases. This broke the truce in the Sino-U.S. trade war that accompanied the resumption in negotiations last month. Feature A recovery in industrial-commodity demand – particularly for oil and base metals – could be stretched out longer than we expected just a week ago. It’s still too early to tell whether the escalation in Sino-U.S. trade tensions will throw a spanner into the revival of commodity demand we’ve been expecting, but it does give us pause. Prior to the political shocks and other disappointments hitting markets this past week, our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. EM GDP growth drives commodity demand growth globally, which is why it is so important in our analysis. Our Chart of the Week illustrates this point, showing three relationships we've developed that allow us to track the evolution of EM GDP growth in something close to real time: BCA’s Global Industrial Activity (GIA) index, which is highly sensitive to economic activity in EM generally and China in particular;3  BCA’s Global Commodity Factor (GCF), which condenses the information contained in 28 commodity price series to a common factor using principal components analysis; and BCA’s EM Import Volume model, which generates an expectation of EM import volumes using mainly FX values for countries highly exposed to global trade. To be precise, we find the output of these three models shown in the Chart of the Week and EM GDP growth are deeply entwined.4 As can be seen in the chart, these models appeared to have bottomed and were preparing to hook up. This is supported by current global activity indicators (CAIs), particularly for China and EM, which still is showing positive y/y growth, even if its rate is slowing. (Chart 2), and the recent upturn in EM Financial Conditions we track here at BCA Research (Chart 3).  Chart 2Global CAIs Support EM Growth Expectation Global CAIs Support EM Growth Expectation Global CAIs Support EM Growth Expectation Chart 3EM Financial Conditions Move To Easier Setting EM Financial Conditions Move To Easier Setting EM Financial Conditions Move To Easier Setting However, the escalation of Sino-U.S. trade tensions, coming off a somewhat disappointing Fed rate cut of 25bps and weak manufacturing data, was enough to erase 6% and 3% from the GSCI and Bloomberg commodity indices over the week ended Tuesday (Chart 4), and to lift volatility in industrial commodities’ prices sharply (Chart 5).5    Chart 4Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Chart 5Crude Oil, Copper Vol Jump On Policy Shock Crude Oil, Copper Vol Jump On Policy Shock Crude Oil, Copper Vol Jump On Policy Shock   A Fraught Situation The Sino-U.S. trade standoff is fraught with risk for both sides. A full-blown trade war could devolve into domestic recessions (there is a non-trivial risk to the global economy, as well). In addition, a kinetic military confrontation between China and its allies and the U.S. and its allies cannot be ruled out, as tensions rise. The case for resolving the trade dispute is strong. Our colleague Peter Berezin notes that while an escalation in the Sino-U.S. trade war “would tip the scales towards recession, the risk of such an outcome remains low.”6 An all-out trade war could push the U.S. economy into a recession next year, just as President Trump faced re-election, which strongly suggests a goodwill gesture or two from the U.S. – e.g., the Commerce Department renewing the licenses allowing U.S. firms to deal with Huawei – could go a long way to getting trade talks back on track.  Our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. That said, we cannot gainsay the conclusions of our colleague Matt Gertken, who runs our Geopolitical Strategy: “The U.S.-China trade negotiations are falling apart at the moment. … (B)ut 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,” as U.S. and Chinese positions harden, particularly around North Korea, Hong Kong and Taiwan.7 Clearly, the outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated. Moving To A Safe Haven: Silver While we continue to expect global fiscal and monetary stimulus will revive commodity demand, the shocks and disappointments visited upon markets could incline firms, households and investors globally to scale back on risky investments and purchases until the dust settles.8  Over the near term – i.e., 3 months or so – seeking refuge in a safe haven is sensible. In particular, we believe silver offers near-term cover, and expect it will continue to follow the evolution of gold prices.9  We expect central banks generally – the Fed in particular – will err on the side of maintaining monetary accommodation while uncertainty over trade and global growth prospects remains elevated. Fed Chairman Jay Powell's description of the central bank's July rate cut of 25 bps as a mid-cycle adjustment – and not the beginning of a lengthy cutting cycle – was perceived as a hawkish surprise, but markets appear to be pricing in additional cuts this year, which will support precious metals until further guidance from the Fed arrives. An escalation of the trade war likely would increase the probability the Fed cuts rates further at its next meeting, which would push down recession fears. The outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated.   On the supply side, silver typically is mined as a secondary metal, and usually is found with gold, copper and lead deposits, according to the Silver Institute.10 On the demand side, investment and electronics account for much of the usage. Prior to the Global Financial Crisis (GFC), silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization, which led to higher consumption. This resulted in a large supply-deficit in most industrial commodities, including silver (Chart 6). Following the GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. (Chart 7).11  Chart 6Silver Is Less Industrial, More Precious Now Silver Is Less Industrial, More Precious Now Silver Is Less Industrial, More Precious Now Chart 7Post-GFC, Silver and Gold Are More Closely Aligned Post-GFC, Silver and Gold Are More Closely Aligned Post-GFC, Silver and Gold Are More Closely Aligned We expect this to continue, given our view central banks are likely to either increase or accelerate monetary accommodation to offset Sino-U.S. trade tensions, should they worsen. The U.S. dollar outlook remains important for precious metals. The dollar is a counter-cyclical currency. Thus, the escalation in trade tensions risks delaying the rebound we expect in emerging markets. This could support the USD for longer than we expected. Bottom Line: We expect commodity demand to revive on the back of global fiscal and monetary stimulus. However, exogenous political shocks along the way toward that revival likely will force households, firms and investors to re-think spending and investment decisions. This could potentially lead to reduced aggregate demand, in the event uncertainty around manufacturing, which still accounts for significant employment and output in EM economies, and global trade becomes too high. Until this is sorted, taking refuge in a safe haven is prudent. To hedge against this, we are recommending spot silver as a tactical portfolio hedge. We already are long gold as a strategic portfolio hedge, and this position is up 20% this year.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   1      Please see U.S. sanctions waiver for Chevron signals Venezuela solution near: opposition ambassador, published by S&P Global Platts July 30, 2019. 2      Please see U.S. farmers suffer 'body blow' as China slams door on farm purchases published by reuters.com August 5, 2019. 3      Please see Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published by BCA Research’s Commodity & Energy Strategy May 9, 2019, for a discussion of the GIA index. The index is a weighted average of selected trade, currency, manufacturing PMIs, and Chinese industrial sector variables. The article is available at ces.bcaresearch.com. 4      This is to say there is strong two-way Granger causality between EM GDP and the output of the models shown above in the Chart of the Week. Knowing the output of one of the models allows one to forecast EM GDP growth, and vice versa. We will be doing further research into using these models to estimate the change in EM GDP at a higher frequency than the stand-alone EM GDP data are reported – e.g., the World Bank’s most recent actual EM GDP data in constant 2010 USD is reported up to 1Q18, while the models shown in the chart can be updated daily (GCF and the EM Import Volume models); and monthly, as the components of the GIA index become available. 5      For a discussion of global fixed-income markets’ response to the escalation of the Sino-U.S. trade war and the outlook for more aggressive monetary policy accommodation globally, please see Trade War Worries: Once More, With Feeling, published by BCA Research’s Global Fixed Income Strategy August 6, 2019. It is available at gfis.bcaresearch.com. 6      Please see A One-Two Punch, published by BCA Research’s Global Investment Strategy August 2, 2019. It is available at gis.bcaresearch.com. 7      Please see Tariffs ... And The Last Prime Minister Of The United Kingdom?, published by BCA Research’s Geopolitical Strategy, August 2, 2019. It is available at gps.bcaresearch.com.  Almost on cue, China warned the U.S. it would view its deployment of intermediate-range missiles in Asia following Russia’s revival of its intermediate-range missile development as “offensive in nature.” Please see China warns US against deploying missiles on its ‘doorstep’, published by the Financial Times August 6, 2019.  8      Our global macro expectation can be found in Oil Markets Await Lift From Global Stimulus, published by BCA Research’s Commodity & Energy Strategy August 1, 2019. It is available at ces.bcaresearch.com. 9      Please see "The Gold Trifecta," published June 27, 2019, by BCA Research's Commodity & Energy Strategy, for our most recent analysis of the gold market and of our long-held bullish gold view. It is available at ces.bcaresearch.com. 10     The Institute’s supply-demand annual supply-demand balances showed a 29.2mm-ounce deficit in 2018. 11     When we model silver returns as a function of gold and base metals’ returns, silver’s elasticity to gold prices more than doubles – from 0.68 over the 1999 - 2010 period, to 1.67 post-GFC (2010 to now). The elasticity to changes in base-metals prices was roughly cut in half over this period, to 0.28 post-GFC.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Dear Client, In case you missed it in real time, please listen to a replay of this quarter’s webcast ‘The Investment World in 5 Charts and 18 Minutes’ available at eis.bcaresearch.com. Also please note that we will be taking a summer break, so our next report will come out on August 22. Dhaval Joshi Highlights The aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from a down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector and regional losers and winners. Economically-sensitive ‘value’ sectors will be the losers, specifically Industrials and Semiconductors. Defensive ‘growth’ sectors will be the relative winners, specifically Healthcare. Continue to overweight European equities versus Chinese equities. Feature Chart of the WeekThe Global Bond Yield Is Within A Whisker Of An All-Time Low The Global Bond Yield Is Within A Whisker Of An All-Time Low The Global Bond Yield Is Within A Whisker Of An All-Time Low This week the global long bond yield came within a whisker of the all-time low reached after the shock vote for Brexit in June 2016 (Chart of the Week). By definition, this means that the aggregate bond market has gone nowhere for several years. Since the autumn of 2017, the aggregate equity market has also gone nowhere, with no rally or sell-off lasting more than three months (Chart I-2).1 Chart I-2Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months The correct strategy then has been to sell the equity market’s three month rallies and buy the three month sell-offs. In June we predicted that equities would end the year at broadly the same level as then, but that they would experience a dip of at least 4-5 percent along the way. We are now experiencing the dip. The correct strategy has been to sell the three month rallies and buy the three month sell-offs. But isn’t the global bond yield approaching an all-time low a good thing for the economy and equity market? The answer is yes, and no. Yes, the ultra-low level of yields is a boon for the valuation of risk-assets. However, when it comes to credit-sourced economic growth, what matters is not the level of the bond yield, nor its direction, so much as its rate of change.      If Bond Yields Decline At A Reduced Pace, Growth Slows Many people struggle to understand this subtle and counterintuitive point. If the bond yield declines, but at a reduced pace, it can slow credit-sourced growth. To understand why, imagine that in a certain period, a -0.5 percent decline in the bond yield added €50 billion to credit creation. This would constitute additional economic demand. If, in the following period, a further -0.5 percent yield decline added another €50 billion of credit-sourced demand, it would constitute the same amount of additional demand – which is to say, the same growth – as in the first period. By comparison, a -0.25 percent yield decline which added €25 billion to demand would result in the growth rate halving. The subtle and counterintuitive point is that the bond yield has continued to decline, yet it has caused credit-sourced growth to slow! Chart I-3In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago This counterintuitive dynamic has unfolded in the global economy this year. Although bond yields have been heading lower, the peak rate of decline – notably in China – happened six months ago. Meaning that credit-sourced growth has almost certainly slowed (Chart I-3). Amplifying this down-oscillation in growth, geopolitical storm clouds are now regathering over the global economy. In the early part of this year, trade tensions and currency wars between the major economic blocs seemed to dissipate, the Middle East was quiet, and the Brexit deadline was postponed. But the lull was temporary. The geopolitical headwinds to growth are now strengthening with a vengeance. That’s the bad news.  Equity Valuations Are Hyper-Sensitive To Low Bond Yields Now the good news. While the level of bond yields does not drive economic growth, it does drive the valuations of equities and other risk-assets. Moreover, it does so in a powerful non-linear way. Below a threshold level, ultra-low bond yields can give the valuation of equities an exponential boost. Geopolitical storm clouds are now regathering over the global economy. We refer readers to our other reports for the details, but in a nutshell at ultra-low bond yields the risk of owning bonds converges to the risk of owning equities. The upshot of this risk convergence is that investors price equities to deliver the same feeble nominal return as bonds, meaning that the valuation of equities soars (Chart I-4).2 Chart I-4The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 Theoretically and empirically, this threshold level of the bond yield is in the region of 2 percent. And the bond yield that matters is the global long bond yield, defined as the simple average of the 10-year yields of the U.S., the euro area, and China. To simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China. A value rising towards 2.5 percent equates to danger for equity valuations. A value falling below 2.0 percent equates to an underpinning for equity valuations. Today, the value stands near 1.5 percent creating a good support for equity and risk-asset valuations. The upshot is that the aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from the down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector losers and winners. Essentially, economically-sensitive ‘value’ sectors will be the losers while defensive ‘growth’ sectors will be the relative winners. Put simply, the sector trends present during the last up-oscillation in global growth are likely to unwind if they have not already done so. In which case, the sectors most likely to suffer underperformance are:   Industrials and Semiconductors (Chart I-5). Chart I-5Industrials Outperformed Strongly... But Are Now Underperforming Industrials Outperformed Strongly... But Are Now Underperforming Industrials Outperformed Strongly... But Are Now Underperforming And the sector most likely to see (continued) outperformance is: Healthcare. There will also be regional losers and winners. This is because regional equity market relative performance just follows from sector relative performance combined with each region’s sector ‘fingerprint’. Bear in mind that a fingerprint can be defined not just by overweight sectors but also by underweight sectors, such as the Shanghai Composite’s negligible weighting in Healthcare, making the Chinese index ultra-cyclical. Continue to overweight European equities versus Chinese equities (Chart I-6).  Chart I-6Overweight Europe Versus China Overweight Europe Versus China Overweight Europe Versus China Market Dislocations And Recessions: Cause And Effect As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major dislocation in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months. There have been three such episodes in the twenty-first century.3 Yet our market based definition of a major dislocation also perfectly captures the three last times that the European economy went into recession or near-recession. Does this mean that the recessions caused the financial market dislocations? No. Quite the reverse. The twenty-first century’s recessions have all resulted from financial market dislocations. The twenty-first century’s recessions have all resulted from the financial market dislocations that followed market distortion or mispricing: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-7); the mispricing of U.S. mortgages and credit in 2007 (Chart I-8); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-9). Therefore, the major dislocations in the financial markets have always preceded the recessions and near-recessions, sometimes by several quarters, even when both are measured in real time. Chart I-7The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... Chart I-8...The Mispricing Of U.S.##br## Mortgages And Credit In##br## 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008...   Chart I-9...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 Today, the consensus overwhelmingly believes that a recession will cause the next major dislocation in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Hence, a major dislocation in the financial markets – should one occur – will cause the next recession. And not the other way round! Fractal Trading System* The nickel price has surged on continued fears over Indonesian exports bans. But from a technical perspective the recent surge is excessive and susceptible to a reversal on any easing of the fears. Accordingly, this week’s trade is short nickel versus copper, setting a profit target of 10 percent with a symmetrical stop-loss. In other trades, short ASX200 versus FTSE100 hit its 2 percent stop-loss, but short MSCI All-Country World has moved well into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10Short Nickel, Long Copper Short Nickel, Long Copper Short Nickel, Long Copper The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 We define the global long bond yield as the simple average of the 10-year yields in the U.S., euro area, and China. And to make things simple, France provides a good proxy for the euro area long bond yield. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com. 3 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Chart 1Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio The Fed cut rates by 25 basis points last week, a move that Chairman Powell described as an “insurance” cut meant to counter the risks from trade tensions and global growth weakness. Powell also described the move as a “mid-cycle adjustment to policy” and not “the beginning of a lengthy cutting cycle”. We agree with the Fed’s “mid-cycle” view of the U.S. economy and think an extended cutting cycle is unwarranted, but the market clearly disagrees. Long-end yields fell on Powell’s remarks and fell further as U.S. / China trade tensions re-escalated during the past few days. The 2015/16 period continues to be a good roadmap for the current environment, and we expect the next big move in Treasury yields will be higher. The timing of that move, however, is highly uncertain. Our political strategists expect an increase in saber-rattling between the U.S. and China in the coming months, and bond yields will not rise until either trade tensions ease and/or the global growth data recover. We recommend a tactical neutral allocation to portfolio duration, but expect to switch back to below-benchmark when those conditions are met. The CRB / Gold ratio will continue to be a good guide for the 10-year yield (Chart 1). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in July, bringing year-to-date excess returns up to +432 bps. Corporate spreads widened somewhat following Jerome Powell’s perceived hawkishness at last week’s FOMC meeting, but that spread widening will prove fleeting. The Fed remains committed to keeping monetary policy accommodative and that means doing everything it can to prevent a significant tightening of financial conditions.1 The soaring price of gold is the strongest indicator of the Fed’s dovishness, and it is also a buy signal for corporate credit (Chart 2). In terms of valuation, Baa-rated securities offer the most value in investment grade corporate bond space. Baa spreads remain 7 bps above our cyclical target.2 Conversely, Aa and A-rated spreads are 3 bps and 4 bps below target, respectively (panel 4). Aaa spreads are 16 bps below target (not shown). The Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed that commercial & industrial (C&I) lending standards eased for the second consecutive quarter. C&I loan demand continued to contract, but less aggressively than its recent pace (bottom panel). Easing lending standards usually coincide with spread tightening, and vice-versa.  Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +673 bps. The average index option-adjusted spread tightened 6 bps in July, then widened 26 bps in the first two days of August. At 397 bps, it is currently well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 71 bps above our target (Chart 3), B-rated spreads are 142 bps above our target (panel 3) and Caa-rated spreads are 298 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.9% over the next 12 months, not far from our own projection.4 This would translate into 238 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +32 bps. The conventional 30-year zero-volatility spread tightened 10 bps on the month, consisting of a 9 bps tightening in the option-adjusted spread (OAS) and a 1 bp decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS moved all the way back to its pre-crisis mean, before tightening last month (panel 3). However, as we noted in a recent report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment MBS exposure, especially given the recent downleg in Treasury yields that could spur another small jump in refis. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in July, bringing year-to-date excess returns up to +164 bps. Sovereign debt outperformed duration-equivalent Treasuries by 68 bps on the month, bringing year-to-date excess returns up to +490 bps. Local Authorities outperformed the Treasury benchmark by 31 bps, bringing year-to-date excess returns up to +244 bps. Meanwhile, Foreign Agencies outperformed by 49 bps, bringing year-to-date excess returns up to +153 bps. Domestic Agencies outperformed by 6 bps in July, bringing year-to-date excess returns up to +31 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +36 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 102 basis points in July, bringing year-to-date excess returns up to +58 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 8% in July, and currently sits at 78% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, and even below the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We noted the strong outperformance of municipal bonds in our report two weeks ago, and recommended cutting exposure from overweight to neutral, based on how expensive the bonds have become.6 In that report we noted that Aaa-rated Municipal / Treasury yield ratios for 2-year, 5-year and 10-year maturities were all more than one standard deviation below average pre-crisis levels. Only 20-year and 30-year Aaa-rated municipal bonds continue to look cheap, and we recommend that investors focus muni exposure on that segment of the market. Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our shift to a more cautious stance is driven purely by valuation, and not any immediate concern for municipal bond credit quality. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in July, before undergoing a roughly parallel shift down of about 30 bps in the first two days of August, following the FOMC meeting and news about the escalation of the U.S./China trade war. As we go to press, the 2/10 Treasury slope stands at 16 bps, 9 bps flatter than at the end of June. The 5/30 slope is currently 76 bps, exactly equal to its end-of-June level. Our 12-month Fed Funds Discounter is currently -78 bps (Chart 7). This means that the market is priced for roughly three more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of the uncertainty surrounding the timing of the next move higher in yields, three rate cuts on a 12-month horizon still seems excessive given the underlying strength of the U.S. economy. For this reason we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts spread over the next four FOMC meetings. A short position continues to make sense. On the yield curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +71 bps. The 10-year TIPS breakeven inflation rate rose 8 bps in July to reach 1.77%, before falling back to 1.67% in the first few days of August (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate followed a similar path and currently sits at 1.88%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.7 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at an annualized rate of 2.48% during the past three months. However, the 12-month rate of change remains at 1.5%. The 12-month trimmed mean PCE inflation rate is currently running at 2%, exactly equal to the Fed’s target. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.8 We see continued upside in core inflation over the remainder of the year, and therefore recommend an overweight allocation to TIPS versus nominal Treasuries.  ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in July, bringing year-to-date excess returns up to +59 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. It currently sits at 31 bps, well below the pre-crisis mean of 64 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed a continued tightening in lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). On the bright side, stronger demand for both credit cards and auto loans was reported for the first time since the fourth quarter of 2016. All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.       Non-Agency CMBS: Neutral     Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to +234 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 64 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation compared to other similarly-rated fixed income sectors.9 Agency CMBS: Overweight   Agency CMBS outperformed the duration-equivalent Treasury index by 26 bps in July, bringing year-to-date excess returns up to +119 bps. The index option-adjusted spread tightened 3 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 78 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of August 2, 2019) Underinsured Underinsured Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of August 2, 2019) Underinsured Underinsured Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +55 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Underinsured Underinsured Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

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 Monthly Portfolio Update: Manufacturing Recession, Consumer Resilience, Dovish Central Banks Monthly Portfolio Update: Manufacturing Recession, Consumer Resilience, Dovish Central Banks Chart 1Heading Downhill Fast Heading Downhill Fast Heading 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... Service Sector Surveys Look Healthier... Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data ...Supported By The Hard Data ...Supported By The Hard Data   Chart 4 Chart 5China Is The Root Cause China Is The Root Cause China 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). 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? Close To The End Of The Down Wave? Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession No Structural Triggers For Recession No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased Financial Conditions Have Eased Financial 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 China's Stimulus Is Only Half-Hearted China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Still Clamping Down On Shadow Banks Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? Have Stocks Already Discounted A Rebound? Have 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 Yields Will Rise With GDP Forecasts Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Some Credit Spreads Look Attractive Some 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 Dovish Fed Is Dollar Bearish Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom Watch AUD/JPY For Signs Of A Bottom Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Oil Has Further To Rise Oil Has Further To Rise Chart 18 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  

Feature GAA DM Equity Country Allocation Model Update Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World The GAA DM Equity Country Allocation model is updated as of July 31, 2019.  The quant model reversed its abnormal upgrade of Sweden in the previous model update. In hindsight, the model’s behavior when a bond yield moves close to zero needs to be watched closely. Currently, the model still favors Spain, Italy, Germany, Netherland and Australia at the expenses of U.S., Japan, U.K., France and Canada, as shown in Table 1.  As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark by 94 bps in July, largely driven by 146 bps of underperformance from the Level 2 model, and 26 bps of underperformance from the Level 1. Directionally, 7 out of the 12 choices generated positive alpha. However, the overweight in Sweden and Spain generated outsized underperformance. Since going live, the overall model has outperformed by 94 bps, with 297 bps of outperformance by the Level 2 model, offset by 42 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of July 31, 2019. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The model’s tilts between cyclicals and defensives have changed compared to last month. Following the Fed’s decision to cut interest rates yesterday, the liquidity component shifted its inputs to phase 4 – a period in which the central bank is cutting rates, while simulative monetary conditions persist. Although this should favor most cyclical sectors, the lack of evidence of global growth bottoming is tilting the model to favor a mixed bag of sectors. The valuation component continues to remain muted across all sectors. The model is now overweight 4 sectors in total, 2 cyclical and 2 defensive sectors. These are Consumer Discretionary, Information Technology, Consumer Staples, and Healthcare. Table 3Model’s Performance (March 1, 2019 - Current) GAA Quant Model Updates GAA Quant Model Updates Table 4Current Model Allocations GAA Quant Model Updates GAA Quant Model Updates   For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 The Fed Apotheosis The Fed Apotheosis Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation Mind The Positive Correlation Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Grim Trade Backdrop... Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits ...Will Continue To Weigh On Foreign Sourced Profits ...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Sales Pressures... Sales Pressures... Chart 5...Are Building Rapidly ...Are Building Rapidly ...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Health Care S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care S&P Managed Health Care S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets S&P Hypermarkets S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials S&P Materials S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology S&P Technology S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Technology Hardware, Storage & Peripherals S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Consumer Discretionary S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Homebuilders S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Telecommunication Services S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment S&P Movies & Entertainment S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps