Australia

Highlights We expect both the Australian dollar and Chinese RMB to move higher in the coming months. A key catalyst is broad-based weakness in the US dollar. The composition of goods benefiting from the US-China Phase I deal are a small portion of Australia’s export basket, limiting substitution. Remain long AUD/NZD and AUD/CAD. Place a limit buy on AUD/USD at 0.68. Feature The three key obstacles that have been hijacking currency markets are finally being addressed. First, the lack of dollar liquidity that was creating a funding crisis in repo markets has been curtailed via significant expansion of the Federal Reserve’s balance sheet. The Libor-OIS spread - a measure of banking stress - is rapidly narrowing (Chart I-1). Second, the US-China trade deal has cemented a cap on economic policy uncertainty for now. At minimum, this should allow for an increase in cross-border flows, which tends to be positive for growth. As a counter-cyclical currency, the US dollar will continue to depreciate as global growth improves. The third obstacle giving way is political risk. The biggest uncertainty for the dollar was the surge in far-left populist candidates, especially Elizabeth Warren. The result would be a highly polarized election campaign, heightening uncertainty. The near-term reaction would be a surge in safe-haven demand, even though far-left policies could significantly knock down expected returns on US assets, which would be negative for the dollar. Chart I-1An Improvement In Dollar Liquidity An Improvement In Dollar Liquidity An Improvement In Dollar Liquidity Chart I-2The Dollar And Election Outcomes The Dollar And Election Outcomes The Dollar And Election Outcomes Chart I-2 shows that the ebb and flow in the dollar in recent months has eerily matched the probability of a Donald Trump–Elizabeth Warren contest. With a centrist like former Vice President Joe Biden now likely the next democratic nominee, the likelihood of a knee-jerk rally in the dollar has subsided. Unless these risks flare up again, this suggests that for the next few months, US dollar long positions face asymmetric downside risk. This creates a growing number of trading opportunities on the short side. Australian Growth And The Fires One of the FX market’s current favorite short positions is the Australian dollar (Chart I-3). Granted, most incoming data over the past year have been negative for the Aussie dollar, and typical global reflation indicators are just beginning to show tentative signs of a bottom. Among our favorite indicators on whether or not easing liquidity conditions are fuelling higher global growth are the copper-to-gold and oil-to-gold ratios. The signal is usually strongest when they are moving in tandem with US bond yields, another global growth barometer. The message so far has been one of stabilization rather than a renewed reflation cycle (Chart I-4). Chart I-3Lots Of AUD Shorts On AUD And CNY On AUD And CNY Chart I-4Reflation Barometers Reflation Barometers Reflation Barometers The devastating fires that are sweeping through Australia are the worst in decades. As we go to press, the death toll has risen to at least 25, and the cumulative damage is expected to exceed A$4.4 billion.1 Given that we are still in the middle of the summer months, both are likely to keep ramping up. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. So far, at A$2 billion, the fiscal pledge will do little to alter Australia’s economic fortunes (Chart I-5). But given the scale of this season’s fires, the effects are rapidly spilling over into urban populated areas and tourist hot spots compared to the past. This suggests more fiscal stimulus will be forthcoming.  Chart I-5The Fiscal Impulse Is Minuscule The Fiscal Impulse Is Minuscule The Fiscal Impulse Is Minuscule Naturally, the odds of the Reserve Bank of Australia cutting rates at its next policy meeting are rapidly rising. The RBA views the risks from climate change through the lens of financial stability.2 With insurance companies slated to rack up significant losses, along with the immediate impact of slower economic growth, lower rates will likely be the policy of choice. The probability of a rate cut next month is currently being priced at 55%. That said, we would still be buyers of the AUD today despite an impending rate cut. Bottom Line: The latest fires have hit the Australian economy at a time when growth is weak. We expect the RBA to cut rates. How To Trade The Aussie For most small, open economies, external conditions tend to be more important for asset prices than what is happening domestically. In the case of the Australian dollar, the commodity cycle has been the most important driver (Chart I-6). Similarly, the most important catalyst for multiple expansion in Australian equities is Chinese credit demand. This makes sense, since over 35% of Australian exports go to China (Chart I-7), generating tremendous income for domestically-listed concerns. Chart I-6AUD Tracks Commodities AUD Tracks Commodities AUD Tracks Commodities Chart I-7Australian Equities And Chinese Credit Australian Equities And Chinese Credit Australian Equities And Chinese Credit Australian exports have remained resilient in recent weeks, and are unlikely to be affected much by the Phase I trade deal. This is because the composition of goods that have been spared additional tariffs or seen much-reduced export duties are mostly consumer goods that make up a small portion of Australia’s export basket. This means that the path of least resistance for Aussie assets will continue to be dictated by Chinese reflationary efforts. On that front, we have seen a number of green shoots, notably the rise in the manufacturing PMI, retail sales, imports and exports. Last night’s credit numbers were also robust. Meanwhile, interest rates in China continue to be lowered. For most small, open economies, external conditions tend to be more important for asset prices.In the case of the Australian dollar, the commodity cycle has been the most important driver. Our favorite indicator for Chinese domestic demand is the lag between the drop in bond yields (more and more credit is being intermediated through the bond market) and the pick-up in import demand. This suggests a very healthy recovery in Chinese consumption (Chart I-8). Chart I-8Chinese Imports And Bond Yields Chinese Imports And Bond Yields Chinese Imports And Bond Yields How to trade the Aussie will depend on time horizons. In the near-term, improving global growth will likely be accompanied by a weakening dollar. This means the most potent trade in the short term will be long AUD/USD. Given our bias that we will get a dovish surprise from the RBA next month, we are instituting a limit-buy on AUD/USD at 68 cents today. Over the longer term, we believe the Australian dollar will outperform its commodity-currency counterparts. In our portfolio, we are already both long AUD/CAD and AUD/NZD. This bullish view is predicated on three key developments: Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. However, the media often focuses on rising steel and iron ore prices as a catalyst for rising terms of trade in Australia. While true, often overlooked is the rising share of liquefied natural gas in the export mix (Chart I-9). Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. Given that reducing if not outright eliminating pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost (Chart I-10). In a nutshell, this is a bet that terms of trade in Australia will continue to outpace those in Canada and New Zealand over the medium-term. Chart I-9LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia Chart I-10A Terms-Of-Trade Tailwind A Terms-Of-Trade Tailwind A Terms-Of-Trade Tailwind Construction Activity: All things equal, natural disasters tend to be ultimately positive for GDP, since the destruction in the capital stock does not go into the GDP equation, but reconstruction efforts do. This is especially the case when the economy is running well below capacity. The downturn in Australian housing on the back of macro-prudential measures has been negative for consumption via the wealth effect and the outlook for residential construction activity. At a minimum, this downturn should stabilize as reconstruction efforts pick up (Chart I-11). Meanwhile, policy has become supportive for Aussie homebuyers at the margin. The government now guarantees first-time homebuyers in Australia below a certain income threshold access to the housing market, with just a 5% down payment instead of the standard 20%. Should labor market conditions improve, it will also help household income levels. Already, the Liberal-National coalition has left in place “negative gearing”3 and kept the capital gains tax exemption from selling properties at 50% (the pledge from the center-left Labour party was to reduce it to 25%). Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand.  Most importantly, Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand. The mirror image has been that Aussie banks have massively underperformed those in Canada (Chart I-12). Over the medium term, we could see a reversal of these fortunes. Chart I-11Capex Should Rise In Australia Capex Should Rise In Australia Capex Should Rise In Australia Chart I-12Aussie Banks Versus Canadian Banks Aussie Banks Versus Canadian Banks Aussie Banks Versus Canadian Banks Valuation And Sentiment: We will show in an upcoming report that while currency valuation is a poor timing tool, it is excellent for calibrating longer-term returns. One of our favorite metrics for gauging the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 18% (Chart I-13). In terms of currency performance, a lot of the bad news already appears priced in the Australian dollar, which is down 15% from its 2018 peak, and 37% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-14). Chart I-13AUD Is Cheap AUD Is Cheap AUD Is Cheap Chart I-14Still Lots Of AUD Shorts Still Lots Of AUD Shorts Still Lots Of AUD Shorts Bottom Line: Place a limit buy on AUD/USD at 0.68. Remain long AUD/NZD and AUD/CAD. Notes On The RMB The currency details from the Phase I trade deal were vague, suggesting monitoring export balances and FX reserves, data that is already available publicly. Our guess is that there was some kind of handshake accord agreed upon to ensure that the RMB does not depreciate significantly in the coming months. More importantly, the RMB will also be a beneficiary from increased cross-border trade, given that it has been trading like a pro-cyclical currency. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-15). It has also closely mirrored the broad trade-weighted dollar (Chart I-16).  Chart I-15CNY And EM Assets CNY And EM Assets CNY And EM Assets Chart I-16CNY And The Dollar CNY And The Dollar CNY And The Dollar This has implications for developed market currencies, since the RMB is often a signaling mechanism on the efficacy of China’s reflationary efforts. Fundamentally, the RMB has more upside. In a world of rapidly falling yields, Chinese rates remain attractive. Historically, the USD/CNY has moved in line with interest rate differentials between the US and China. The current divergence pins the USD/CNY near 6.7 (Chart I-17). Chart I-17USD/CNY Could Touch 6.7 USD/CNY Could Touch 6.7 USD/CNY Could Touch 6.7 Bottom Line: Remain positive on the RMB.  Housekeeping The Canadian dollar is one of the strongest currencies this year. The most recent catalyst was good news from the Bank of Canada’s business outlook survey, a key input into policy decisions. Canadian firms are now expecting an acceleration in both domestic and international sales throughout 2020, particularly outside the energy sector (Chart I-18, top panel). Chart I-18BoC Business Outlook Survey BoC Business Outlook Survey BoC Business Outlook Survey Hiring intentions among surveyed firms edged up in Q4. Meanwhile, many firms reported facing capacity pressures, particularly related to a shortage of labor (Chart I-18, middle panel). This will allow the BoC to overlook weak labor market data in October and November. That said, it is not all clear blue skies for the CAD. The balance of opinion for capex intentions among surveyed Canadian firms plunged in Q4 (Chart I-18, bottom panel). We will be monitoring these developments but remain short CAD/NOK and long AUD/CAD for the time being.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Keith Bradsher and Isabella Kwai, “Australia’s Fires Test Its Winning Growth Formula,” The New York Times, January 13, 2020. 2 Please see “Financial Stability Risks From Climate Change,” Financial Stability Review, Reserve Bank Of Australia, October 2019. 3 The practice of using investment properties that are generating losses to offset one’s income tax bill. 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 US have been mixed: On the labor market front, nonfarm payrolls increased by 145K in December, the smallest increase since May. Average hourly earnings growth slowed to 2.9%, while the unemployment rate was unchanged at 3.5%. Lastly, initial jobless claims fell to 204K for the week ended January 10th. The NFIB business optimism index declined to 102.7 from 104.7 in December. Headline inflation increased to 2.3% year-on-year in December, while core inflation was unchanged at 2.3%. Both the NY Empire State and Philly Fed manufacturing indices rose to 4.8 and 17, respectively in January. The DXY index fell by 0.3% this week. While both headline and core inflation remain close to target, the bearish job report last Friday is likely to reduce the scope for the Fed to raise rates in the near term. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 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 have been mixed: The seasonally-adjusted trade balance fell by €4.8 billion to €19.2 billion in November. Industrial production fell by 1.5% year-on-year in November. German GDP grew by 0.6% year-on-year in 2019, down from 1.5% the previous year. Car registrations rose by a remarkable 21.7% in December. The euro rose by 0.3% against the US dollar this week. "Incoming data since the last monetary policy meeting pointed to continued weak but stabilizing euro area growth dynamics," according to the ECB Meeting Accounts this Thursday. Moreover, both private and government consumption accelerated in 2019, while capex and exports slowed down. A pickup in global growth will be bullish the euro. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 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: Both the coincident and leading indices fell to 95.1 and 90.9, respectively in November. That said, they were above expectations. The current account balance fell to ¥1,437 billion from ¥1,817 billion in November. The trade balance shifted from a surplus of ¥254 billion to a small deficit of ¥2.5 billion. The Eco Watchers' Survey recorded an improvement of current conditions to 39.8 in December, while the outlook index marginally dropped to 45.7. Preliminary machine tool orders continued to plunge by 33.6% year-on-year in December. However, machinery orders increased by 5.3% year-on-year in November. The Japanese yen depreciated by 0.4% against the US dollar this week. The recent Eco Watchers' Survey was cautiously positive on the Japanese outlook. We continue to recommend the Japanese yen as a safe-haven hedge. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 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 Recent data in the UK have been weak: Core CPI fell to 1.4% while core PPI declined to 0.9%. The total trade balance (including EU) rose from a deficit of £1.3 billion to a surplus of £4 billion in November. Industrial production fell by 1.6% year-on-year in November; manufacturing production also fell by 2% year-on-year in November. The notable improvement was in car registrations that rose 3.4% year-on-year in December. The British pound fell by 0.2% against the US dollar this week. The recent drop in inflation has undoubtedly put more pressure on the BoE to reduce rates in the coming policy meeting late January. The market is now pricing in a 66% probability for a rate cut, up from 40% a week ago, while a 25 bps cut is fully priced in by May.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 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 mostly negative: The AiG services PMI fell to 48.7 from 53.7 in December. Retail sales increased by 0.9% month-on-month in November. Melbourne Institute headline inflation fell to 1.4% from 1.5% year-on-year in December. Home loans increased by 1.8% month-on-month in November, higher than expectations of a 1.4% increase. The Australian dollar is flat this week. The ongoing wildfires continue to impact the Australian economy, particularly the tourism industry. Please refer to our front section for a more in-depth analysis on Australia. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 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 Recent data in New Zealand have been soft: Building permits fell by 8.5% month-on-month in November. REINZ house prices grew by 1.2% month-on-month in December. The New Zealand dollar has been flat versus the US dollar this week. The recent quarterly survey from the New Zealand Institute of Economic Research (NZIER) showed that a net 21% of firms surveyed expected business conditions to deteriorate, an improvement from 40% in the previous survey. Improving data has led speculators to close NZD shorts. Stay long AUD/NZD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 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 positive: The unemployment rate fell further to 5.6% from 5.9% in December. Average hourly wage growth slowed to 3.8% from 4.4% year-on-year in December. 35.2K new jobs were created compared to a loss of 71.2K jobs the previous month. The Canadian dollar increased by 0.1% against the US dollar this week. The recent BoC Business Outlook Survey indicator edged up in Q4, lowering the probability that the BoC will cut interest rates next week. That said, the forecast for weak investment spending is worrisome. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 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 There was scant data out of Switzerland this week: The unemployment rate was unchanged at 2.3% in December. The Swiss franc has appreciated by 1% against the US dollar, making it the best performing G10 currency this week. It is an open question whether the US Treasury’s move to put the Swiss franc on the currency manipulation watch list was a catalyst.  What is clear is that interventions in recent weeks have been weak. Meanwhile, the last inflation reading from Switzerland was positive, reducing the urge for the SNB to intervene. EUR/CHF is approaching our limit buy position at 1.06. Stay tuned. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 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 mixed: The producer price index fell by 2.2% year-on-year in November. Both headline and core inflation fell to 1.4% and 1.8% year-on-year, respectively in December. The trade surplus increased to NOK 25.6 billion from NOK 18.8 billion in December. The Norwegian krone has been flat against the US dollar this week. Both inventory reports from API and EIA have been bearish on oil prices, which put a cap on petrocurrencies this week. However, going forward, we continue to believe that the combination of expansionary monetary and fiscal policy will support commodity demand growth in 2020, which is bullish for the Norwegian krone. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 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: Industrial production increased by 0.4% year-on-year in November. Manufacturing new orders fell by 1.2% year-on-year in November. Headline inflation was unchanged at 1.8% year-on-year in December. The Swedish krona rose by 0.2% against the US dollar this week. The Swedish government cut the forecast of GDP growth to 1.1% this year, down from the previous figure of 1.4% in September. Moreover, it forecasted negative rates going forward. That said, valuations and improving global growth will remain strong catalysts for long SEK positions. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2019.  The model made two significant changes to its allocations this month. First, the allocation to the US is now neutral from underweight previously; second, Australia becomes the second largest overweight (from underweight previously), largely due to an improvement in liquidity conditions. Japan, the UK and France remain the three large underweight countries, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in December by 7 bps, driven by the outperformance from the Level 2 model (17 bps), especially the overweight of Spain and underweight of Japan. The Level 1 model also generated one basis point of outperformance from the slight underweight in the US. Since going live, the overall model has outperformed by 64 bps, with 270 bps of outperformance by the Level 2 model, offset by 58 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US 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 US Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) For more on historical performance, please refer to our 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 as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of December 31, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model have turned bullish, based on rising metal prices and EM currencies appreciating relative to the US dollar. This in turn led the model to reverse its defensive overweight it had instated last month on Consumer Staples and favor more cyclical sectors. The valuation component remains muted across all sectors except Energy. The accommodative stance likely to be implemented by global central banks will continue to lead the model to favor a mixed bag of cyclical and defensive sectors. The model is now overweight five sectors in total, four cyclical versus one defensive sectors. These are Consumer Discretionary, Information Technology, Financials, Materials, and Health Care.     Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Overall Model Performance 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.   Table 4Current Model Allocations GAA Quant Model Updates GAA Quant Model Updates   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com  

Highlights Net inflows into US assets have been rolling over since the beginning of 2019, given that the repatriation associated with the 2017 tax cuts was a one-off effect. Besides, fading interest rate differentials are making US Treasuries less attractive, which is a headwind for the greenback.  A trade war ceasefire between the US and China should improve the balance of payments dynamics for export-oriented nations. We maintain a pro-cyclical stance.  A revival in oil demand and curbs on supply should underpin oil prices through 2020, which could lift the trade balances of Norway and Canada. However, we expect the Canadian dollar to underperform, weighed by pipeline constraints and the divergence between WCS and WTI prices. Stay short CAD/NOK. Feature The balance of payments is one of the key indicators we watch on a regular basis to gauge the direction of exchange rates. While the power of BoP on currency moves differs from one country to another, it provides a big picture view of a country's transactions with other nations. Generally speaking, persistent surpluses are usually associated with appreciation in currencies, and vice versa. Ongoing trade disputes since early 2018 have caused some fluctuation in current account balances globally. Political uncertainties and rising protectionism have also limited foreign investments in some countries. Going forward, should global growth stabilize amid a possible trade détente, export-oriented regions will have more scope to improve their balance of payments dynamics. In what follows we present balance of payments across G10 through five categories: the trade balance, the current account balance, foreign direct investment, the basic balance, and lastly, portfolio investment. United States Chart 1US Balance Of Payments US Balance Of Payments US Balance Of Payments The US trade deficit has been more or less flat, lingering around 3% of GDP. The trade deficit mostly comes from manufactured goods. On the positive side, the US has been producing and exporting more petroleum and related products, which has decreased oil demand from abroad. Meanwhile, exports of pharmaceutical products are on the rise. The current account is at a smaller deficit of 2.5% of GDP, thanks to a positive net international investment position. Foreign direct investment had been increasing due to repatriation by US companies since the 2017 Trump tax cuts. If this one-off tax break was a source of US dollar strength in 2018, that support is now gone. Meanwhile, dollar strength since the beginning of 2018 may have made US assets less attractive to foreign investors. Since the beginning of 2019, net inflows into US assets have been rolling over, and have fallen to 0.9% of GDP. This has brought the US basic balance down to -1.6% of GDP. In terms of portfolio investment, US bond markets are still appealing to foreign investors, but interest rate differentials are moving against the greenback. Total foreign purchases of US Treasury bonds have been negative this year, of which official purchases stand at US$350 billion of net outflows. In short, the path of least resistance for the US dollar is down, due to a widening current account deficit, waning foreign direct investment, fading interest rate differentials and increasing dollar liquidity. Euro Area Chart 2Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The slowdown in global trade has hit European exports, but the trade balance is still sporting a “healthy” surplus of 1.7% of GDP, albeit far below its peak. As a result, the current account as of September 2019 was still at a healthy level of 2.7% of GDP. Should a US-China "phase one" deal be finalized, the trade balance in the euro area is likely to rebound going into 2020. Foreign direct investment has been increasing to the point of being at its highest level over the past 20 years, or 1% of GDP. This has been aided in part by the peripheral countries, further evidence that we are getting a convergence in competitiveness across Eurozone countries. The cheap euro and lower cost of capital have helped. As a result, the basic balance for the euro area reached a new high of 3.8% of GDP in September 2019. Portfolio investment into the euro area has stopped deteriorating since the beginning of 2017 and is now sporting net inflows of 0.8% of GDP. European purchases of both foreign equities and foreign bonds are falling, probably a sign that domestic assets are becoming more attractive. For example, ETF inflows are accelerating. The restart of the European Central Bank’s asset purchase program will continue to act as an anchor for spread convergence in the euro area. Meanwhile, a rally in European equities will be another signal of recovery in the euro area. A healthy current account balance and improving foreign investments both signal a higher euro going forward. Japan Chart 3Japanese Balance Of Payments Japanese Balance Of Payments Japanese Balance Of Payments The trade slowdown has dealt a small blow to Japan’s current account balance. The trade deficit widened further in 2019, reaching -0.5% of GDP in Q3. Exports have been falling for a 10th consecutive month, weighed down in part by lower sales of auto parts and semiconductor equipment. But these will pick up should a trade truce be reached. Among its major trading partners, sales to the US, China and other Asian countries have fallen, but have risen in the Middle East and Western Europe. That said, Japan’s large net international investment position has helped keep the current account surplus at an elevated level of 3.4% of GDP. Foreign direct investment in Japan has been dismal for many years due to an offshoring of industrial production. Net FDI is currently standing at -4% of GDP, which has brought the basic balance below zero for the first time since 2016. The recent deceleration is further evidence that corporate Japan needs structural reforms. Portfolio investment remains in negative territory mostly due to Japanese residents' large purchases of foreign long-term bonds. Going forward, fund inflows to Japan could face more headwinds with the proposed change to the Foreign Exchange and Foreign Trade Act. The change aims to lower the minimum stake for foreign investors without government approval from 10% to 1%. Other changes include requiring foreign directors to seek permission before becoming a board member. That said, Japan’s large net international investment position, which produces a high current account surplus, will continue to make the yen a safe haven amid global uncertainties. United Kingdom Chart 4UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments So far, a cheap pound has not yet staunched the deterioration in UK balance of payments. The UK trade deficit remained wide at 7% of GDP in the third quarter. Among its major trading partners, the trade deficit comes mainly from Germany and China, offset by a smaller surplus from the US, the Netherlands and Ireland. Net receipts are positive, but the current account balance is still in negative territory at -5% of GDP. The Brexit imbroglio has led to an exodus of foreign direct investment. Many international companies are fleeing the UK, but to the extent that we get a quick resolution after the December elections, the uncertainty is likely to subside. Portfolio investment in the UK has been volatile over the past few years and has not really helped dictate any discernable trend in the UK basic balance. More recently, inflows into UK gilts have been £19 billion in the second quarter, while flows into equities are also improving. Relative interest rate differentials are also likely to move in favor of the UK, especially if reduced uncertainty provides scope for the Bank of England to hike interest rates. At a minimum, compared with other European nations, gilts remain appealing to international investors. We remain positive on the pound and are long GBP/JPY in our portfolio. Canada Chart 5Canadian Balance Of Payments Canadian Balance Of Payments Canadian Balance Of Payments The Canadian trade deficit has been hovering near -1% of GDP over the past few years. The goods trade deficit narrowed this year, led mostly by an increase in energy exports and lower imports of transportation equipment. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between WCS and Brent crude oil prices. The current account deficit has been narrowing, now standing at -2% of GDP, the smallest since 2008. This is helped by net receipts, especially driven by a rise in direct investment income. FDI has been the bright spot in Canadian BoP dynamics. FDI inflows have been in part helped by increased cross- border M&A activities. Net FDI into Canada now accounts for 2.7% of GDP. This has brought the basic balance back above zero for the first time since 2015. Portfolio investment is positive on a net basis, but the trend looks quite worrisome. Foreign entities are fleeing Canada. In the meantime, Canadian investment in foreign securities is on the rise, reaching C$6 billion in Q3. Profitability, liquidity concerns and a global push towards sustainable investing are making Canadian energy and mining companies unappealing for foreign capital. Moreover, with elevated house prices and depressed interest rates, the outlook for banking profitability is also concerning. A drop in the US dollar will help the loonie in the short term. Over the longer term, however, we prefer to be underweight the Canadian dollar, especially via the Australian dollar and the Norwegian krone, which have a better macro outlook. Australia Chart 6Australian Balance Of Payments Australian Balance Of Payments Australian Balance Of Payments Australia has seen the best balance of payments improvement among the G10. The Australian trade balance soared this year and now stands at 2.5% of GDP, the highest in several years. Terms of trade, which have increased by 45% since their 2016 bottom, have been one of the main drivers. Exports of iron ore and concentrates increased by 64% year-on-year in September 2019, adding to the positive trade balance. Ergo, Australia is benefitting from both a price and volume boost. Trade has lifted the current account to be on track to post its first surplus since the ‘70s. Going forward, we expect Australian trade to continue improving amid the US-China trade détente. Foreign direct investment dipped slightly in 2019, but from very elevated levels. At present, it still stands at 3.5% of GDP. This has allowed for a very healthy basic balance surplus of 2.9% of GDP. The largest sources of Australian foreign direct investment are the US and the UK. The FDI inflows tend to be concentrated in the mining and manufacturing sectors and generate a negative income balance for Australia. This has been part of the reason behind the country’s chronic current account deficit, but it is impressively becoming less and less important. Portfolio investment in Australia plunged in 2019, and now stands at -4.2% of GDP. This has been driven by an exodus from the bond market. The repatriation of capital back to the US probably helped exacerbate this trend. The Australian dollar is likely to rebound from a contrarian perspective. We are playing Aussie dollar strength via the New Zealand and Canadian dollars. New Zealand Chart 7New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand is also benefitting from a terms-of-trade boost. The trade deficit marginally narrowed to -1.7% of GDP in the third quarter. Exports rose by 4% year-on-year in the third quarter, while imports rose by 3.6% year-on-year. Terms of trade increased in 2019, mainly driven by a rise in dairy and meat prices. It appears the pork crisis in China is benefitting New Zealand exports. As a result, the current account deficit narrowed slightly to 3.4% of GDP. Foreign direct investment in New Zealand rose sharply to 3.1% of GDP, partly driven by reinvestment in the banking sector. This almost brought the basic balance back into positive territory. If this trend continues, it will be the first time the basic balance is in positive territory in two decades. Portfolio investment in New Zealand has been deteriorating, with net outflows of $6.2 billion in the second quarter. This is almost 4% of GDP on an annualized basis. The withdrawal of equity and investment fund shares by foreign entities, as well as divestment of debt securities by the general government, are some of the reasons behind falling portfolio investment. In a nutshell, increased portfolio investment in New Zealand will be predicated on a terms-of-trade shock that boosts margin growth for agricultural exporters, or a policy shift that boosts domestic return on capital. We like the kiwi versus the dollar, but are underweight against its pro-cyclical peers, namely the Australian dollar and the Swedish krona. Switzerland Chart 8Swiss Balance Of Payments Swiss Balance Of Payments Swiss Balance Of Payments The Swiss trade balance has been in a structural surplus, and hugely underpins the nation’s large current account surplus. The improvement this year, a rebound to 5.4% of GDP in the third quarter, is notable. The increase in exports has been partly driven by higher sales of chemical and pharmaceutical products, jewelry, and metals. Combined with income inflows from its large net international investment position, this has produced a current account balance of 10.7% of GDP. The slowdown in foreign direct investment has eased sharply from a record-low of -16% to -8% of GDP. Tax breaks from the US Jobs Act in 2017 allowed for favorable divestment of FDI in Switzerland and repatriation back to the US. This was a one-off that is now behind us, which explains why the basic balance is shifting back into surplus territory, to the tune of 2.5% of GDP.  Portfolio investment has been gradually improving and now stands at 0.3% of GDP. Swiss paper and equities (which are defensive) have benefitted from increased safe-haven demand this year. The Swiss franc is likely to continue its slow structural appreciation in the years to come, interspersed with bouts of volatility. In the short-term, however, the Swiss National Bank is likely to use the currency to fight deflationary pressures. This suggests the EUR/CHF has upside tactically. Sweden Chart 9Swedish Balance Of Payments Swedish Balance Of Payments Swedish Balance Of Payments The Swedish trade balance has been in structural decline since 2004 and turned negative in 2016. A large component of Swedish exports are machinery and automobiles which have suffered stiff competition from other global giants. The good news is that the weak krona is starting to help. The third-quarter trade balance shifted to a surplus for the first time since 2016 and is currently standing at 0.2% of GDP. Combined with inflows from Sweden’s external investments, this has nudged the current account balance to 3.3% of GDP. Despite net FDI inflows falling to -2.1% of GDP, the basic balance still managed to remain stable at 1.2% of GDP due to the improvement in the current account balance. The recent decline in Swedish FDI has mirrored those in other countries. However, Swedish exports will benefit from a trade détente as well as from a broader improvement in global growth. This should stem FDI outflows. Net portfolio investment in Sweden has been volatile in recent years, but our expectation is for improvement. A weak krona has typically helped the manufacturing sector with a lag of 12 months. Moreover, with the krona trading at a large discount to its long-term fair value, foreign investors will likely benefit from both equity and currency returns, should cyclical stocks continue to outperform defensives. In summary, Sweden’s basic balance should recover to levels that have prevailed over the past few years. Norway Chart 10Norwegian Balance Of Payments Norwegian Balance Of Payments Norwegian Balance Of Payments The bottom in oil prices since 2016 has gone a long way towards improving Norway’s trade balance. Net trade has fallen marginally this year due to lower exports of oil and natural gas, but still stands at 7.2% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 6.4% of GDP. Norway has seen an exodus of foreign capital from both direct and portfolio investment.  Net FDI and portfolio investment stand at -3% and -4% of GDP, respectively. Declining oil production in the North Sea has been partly responsible for falling FDI. On the portfolio side of the equation, it has been mainly due to increased purchases of foreign equities and bonds, especially via the Oil Fund. Concerns around sustainable investing have also likely diverted investors away from Norwegian assets. Despite this, Norway still sports a basic balance surplus of 3.4% of GDP. Eventually, this basic balance will move from being supported by trade to income inflows from Norway’s large net international investment position. The Norwegian krone is cheap on many metrics, and is one of our favorite petrocurrencies at the moment. Should global growth stabilize, which will revive oil demand, inflows into Norway should improve.   Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global High-Yield: The widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks. Feature There’s Nothing To “Caa” Here The clouds of pessimism on global growth, and financial markets, continue to slowly dissipate. The global manufacturing PMI has clearly bottomed, our rising global leading economic indicator is signaling more upside for the first half of 2020, equity markets worldwide are grinding higher, volatility is subdued, while corporate credit spreads in the US and Europe remain generally tight. Yet within the corporate bond market, a peculiar dynamic has emerged. We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy. The option-adjusted spread (OAS) for the overall Bloomberg Barclays US high-yield (HY) index now sits at 376bps. While this spread is relatively narrow from a longer-term perspective, investors may have become more discerning about credit risk. Lower-rated HY has dramatically underperformed higher-rated HY debt of late, with the US Caa-rated OAS now sitting at 985bps compared to Ba-rated spreads of 196bps (Chart of the Week). The divergence across credit tiers is unprecedented, in that Caa spreads are widening while Ba spreads are narrowing – typically, spreads move in tandem directionally, both in bull and bear markets for US junk bonds. The widening of US Caa-rated junk bond spreads has started to raise concerns that this is a “canary in the coal mine” signaling future financial stress among US corporate borrowers. Yet the same dynamic is occurring in euro area HY, with Caa-rated and Ba-rated spreads tracking the US on an almost tick-for-tick basis. In a report published yesterday, our colleagues at BCA Research US Bond Strategy investigated the history of Caa spread widenings dating back to 1996.1 They noted that Caa spread widening has typically been a good predictor of one-year-ahead negative excess returns for the overall US junk bond index. However, there has never been a period like today where Caa spreads have widened while overall HY spreads have remained stable. Chart of the WeekSome Odd Divergences In Global Credit Some Odd Divergences In Global Credit Some Odd Divergences In Global Credit We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy, for two main reasons: Chart 2Lower Energy Prices Hurt Lower Rated US HY Lower Energy Prices Hurt Lower Rated US HY Lower Energy Prices Hurt Lower Rated US HY 1) The widening is focused on Energy related debt The widening of US Caa-rated spreads in 2019 has occurred alongside a parallel increase in the spreads of Energy-related companies in the US junk bond universe (Chart 2). A similar trend played out during the 2014/15 HY bear phase, which was triggered by the collapse of world oil prices that ravaged the US shale oil industry which dominated the lower-rated tiers of the junk bond market. In 2019, oil prices have declined, although not as dramatically, and HY Energy spreads have widened but to nowhere near the levels seen five years ago. More importantly, non-Energy junk spreads remain very subdued and stable, unlike the case in 2014/15 (bottom panel). When looking at the 2019 year-to-date excess returns for the Bloomberg Barclays US HY index, it is clear that the overall negative returns for the Caa-rated bucket have been driven by the lagging performance of Energy names (Chart 3). The rest of the market has generally been delivering solid excess returns. Chart 3Contribution To 2019 YTD US HY Excess Returns* The Lowdown On Low-Rated High-Yield The Lowdown On Low-Rated High-Yield 2) The widening has not been confirmed by signals from other reliable credit cycle indicators We believe that, from a top-down macro perspective, corporate credit performance in the US is influenced by three main factors: the state of US corporate health, the stance of the Fed’s monetary policy and the trend in lending standards for US banks. We have dubbed this our “Credit Checklist”, and we present a version of that checklist for US high-yield in Chart 4. Chart 4Conditions Not In Place For A Broad US HY Selloff Conditions Not In Place For A Broad US HY Selloff Conditions Not In Place For A Broad US HY Selloff Our “bottom-up” US HY Corporate Health Monitor (CHM) aggregates, for a sample set of US HY issuers, published financial ratios that are typically used to determine the creditworthiness of borrowers – measures like interest coverage, operating margins and leverage. The US HY CHM is currently at a “neutral” reading (2nd panel), unlike past periods where Caa-rated spreads widened sharply: during the early 2000s telecom bust, the 2008 Financial Crisis and the 2014/15 collapse in oil prices. The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual. Turning to measures of the stance of US monetary policy, we look at both the slope of the US Treasury curve (2-year vs 10-year) and the gap between the real fed funds rate and the New York Fed’s estimate of the neutral “r-star” rate. Prior to the early 2000s and 2008 blowout in Caa spreads, the Fed had pushed the real funds rate into restrictive territory above r-star, and the Treasury curve subsequently inverted. That was not the case during the 2014/15 Caa widening, as the Fed was only beginning to transition away from its QE/zero-rate era at that time. Currently, the real funds rate is right at r-star, and the Treasury curve is very flat but not inverted, indicating a broadly neutral monetary policy stance. Finally, we look at data from the Fed’s Senior Loan Officer Survey to evaluate lending standards for US banks. On that front, the latest reading on standards for commercial and industrial loans showed a very modest tightening in the third quarter of 2019, but the overall level remains broadly neutral – unlike the sharp tightening of conditions seen in the early 2000s and 2008 (and the modest tightening in 2014/15). The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual, rather than a sign of future stress in US credit markets. We even see a similar dynamic at work in the euro area. In Chart 5, we present a Credit Checklist for euro area HY, using the same indicators that go into our US HY Credit Checklist. The readings here are even more positive for corporate credit performance than in the US. Our euro area bottom-up HY CHM is showing no deterioration of euro area corporate health, the real ECB policy rate is well below the estimate of r-star, the German yield curve is not inverted and the ECB’s survey of euro area bank lending standards showed a modest easing in the third quarter. Just like in the US, the fundamental backdrop does not argue for a sustained period of euro area HY spread widening, making the latest move higher in euro area Caa spreads as unusual as the move in US Caa. We cannot even blame lower oil prices for the spread widening, as Energy represents only a tiny fraction of the euro area HY market, compared to the large weighting of Energy borrowers in the US junk bond universe. Chart 5Conditions Not In Place For A Broad European HY Selloff Conditions Not In Place For A Broad European HY Selloff Conditions Not In Place For A Broad European HY Selloff We suspect that the correlation between US and euro area HY spreads, by credit tier, has more to do with the increased correlation of trading within global credit markets. Or perhaps it is a sign of investors staying cautious and staying up in quality, even within the riskier HY market. Whatever the reason, we see little fundamental reason to expect the widening of Caa-rated spreads to leak into the broader high-yield market. In fact, if oil prices begin to move higher again, as our commodity strategists are expecting for 2020, that might create a tactical buying opportunity in Caa-rated junk bonds in both the US and euro area. In the meantime, we see no reason to change our recommended overweight stance on US and euro area HY corporate bonds, even with the widening of lower-rated spreads. Bottom Line: The recent widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: The RBA May Not Be Done Yet The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. We have maintained a recommended overweight investment stance on Australian government bonds since December 19, 2017. Since then, the yield on Bloomberg Barclays Australian Treasury index has declined by -140bps, sharply outperforming bonds in the other developed markets and ending Australia’s long-time status as a “high-yielding” developed economy bond market (Chart 6). The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. The central bank has already cut interest rates by 75bps this year, taking the Cash Rate down to a record low of 0.75%. At the November 5th monetary policy meeting, the RBA held off on additional easing but still delivered what was perceived by the market to be a dovish surprise, emphasizing persistently below-target inflation and potential downside risks stemming from the housing market. The door was kept wide open for further rate cuts, if necessary. RBA Governor Philip Lowe has even discussed the possibility that the RBA may have to cut rates to the zero bound and start buying assets via quantitative easing to try and restore inflation back to the midpoint of the RBA’s 2-3% target band. Chart 6Australian Bonds Have Outperformed Sharply Australian Bonds Have Outperformed Sharply Australian Bonds Have Outperformed Sharply   The RBA’s dovishness is justified, given sluggish economic growth and tepid inflation. Real GDP growth slowed sharply in the first half of 2019 to a meager 1.4% on a year-over-year basis (Chart 7). Consumer sentiment and business confidence remain depressed, having both declined since the start of the year. The former is being hit by weak house prices and sub-par income growth, while the latter is suffering under the weight of weaker demand from Australia’s most important trade partner, China. In addition, persistent drought conditions in much of the country have pushed up food prices and brought down incomes related to the farming sector. Chart 7Sluggish Australian Domestic Demand Sluggish Australian Domestic Demand Sluggish Australian Domestic Demand Chart 8From Boom To Bust In Australian Housing From Boom To Bust In Australian Housing From Boom To Bust In Australian Housing A bellwether for the Australian economy, the housing market, has not fared much better (Chart 8). Building approvals for new dwelling units have fallen almost 20% since September of last year, while house prices in the major cities have been contracting since the fourth quarter of 2017. Responding to easy financial conditions in Australia and the rest of the world, the standard variable mortgage rate has now fallen to a 60-year low. It remains to be seen how quickly the housing market will turn around and when that, in turn, will lift dwelling investment, but the RBA cuts in 2019 should give a bit of a lift to Australian housing in 2020. As in other developed markets, trade uncertainty and fears of a recession have made Australian firms more hesitant to invest. Real private business investment is now falling in year-over-year terms, even with the boost to the terms of trade (and corporate profits) from the increase in prices for Australia’s most important commodities seen in 2019 (Chart 9). That impact may be starting to fade, however. The price for iron ore – a major Australian commodity export – has already fallen 28% from the 2019 peak. In addition, Chinese iron ore imports from Australia are contracting in year-over-terms, even with Chinese growth starting to show signs of stabilization in response to stimulus measures implemented earlier this year. Those is an ominous signal for Australian growth, given the massive swing in net exports seen this year. Chart 9Terms Of Trade Turning Negative For Australian Capex Terms Of Trade Turning Negative For Australian Capex Terms Of Trade Turning Negative For Australian Capex Chart 10An Unsustainable Lift From Net Exports An Unsustainable Lift From Net Exports An Unsustainable Lift From Net Exports Driven by the persistent depreciation of the Australian dollar, and supportive terms of trade, the Australian trade balance has reached its highest value as a percent of nominal GDP (3.7%) since 1959, when quarterly data began (Chart 10). The surge has come almost entirely from the export side, occurring alongside the boost to commodity prices that was concentrated in iron ore, and looks both unsustainable and unrepeatable on a rate-of-change basis. Slowing Australian economic momentum has also impacted the labor market. Employment growth is slowing and the unemployment rate has ticked up to 5.3% from a cyclical low of 5% in February 2019 (Chart 11). The so-called “underemployment rate”, is a much higher 8.5%, indicating that there is still ample slack in the Australian labor market as workers are working fewer hours than they wish (and are hence, “underemployed”). The underemployment rate is negatively correlated to wage growth, suggesting that the modest upturn in the latter seen since the end of 2016 is likely to cool off (bottom panel). Chart 11Some Softening In The Australian Labor Market Some Softening In The Australian Labor Market Some Softening In The Australian Labor Market Chart 12Australian Inflation Remains Subdued Australian Inflation Remains Subdued Australian Inflation Remains Subdued The RBA has already warned that wage growth expectations may have become anchored at a lower level given the anemic growth over the past several years. That mirrors the trend seen in overall price inflation. Headline CPI inflation was only 1.6% in the third quarter of 2019, as was the “trimmed mean” CPI inflation rate that is favored by the RBA. Both are below the bottom end of the RBA’s target range of 2-3%, as are survey-based expectations of short-term inflation (Chart 12). The previously mentioned drought conditions have put some upward pressure on overall inflation via grocery food prices, but that is expected to be transitory. With depressed house prices and ongoing issues with spare capacity in the labor market, longer-term market-based inflation expectations, captured by the 5-year/5-year forward CPI swap rate, have dipped below the 2% level. The combination of weakening growth and soggy inflation poses a problem for the RBA, as it tries to use monetary policy tools to reverse those trends at a time when Australian banks have seen an unprecedented level of scrutiny of their lending practices. Australian banks have been under the harsh political spotlight after the government’s Royal Commission on misconduct in the financial industry released its findings back in February of this year. Many banks were exposed for serious violations, including money laundering and “improperly” selling financial products to households. Several top bank executives lost their jobs as a result, with the overall industry duly chastised and humbled.  Australian banks remain well capitalized, following the path of most developed market banks in response to the Basel III reforms, while non-performing loans remain modest. Yet the risk moving forward is that Australian banks become more prudent in their lending practices after the public “flogging” they received this year, which may impair the transmission mechanism from low RBA policy rates to increased loan growth - and, eventually, faster economic activity. Already, private credit growth has slowed sharply, with the sharpest declines coming for housing and business lending (Chart 13). Investment implications for Australian bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. Despite signs that the global economy is starting to bottom out after the 2019 downturn, the momentum in Australian economic growth and inflation remains tepid. This suggests that Australian sovereign debt is likely to continue outperforming global peers on a relative basis over the next 6-12 months. Our RBA Monitor continues to signal that more interest rate cuts from the RBA are needed. Yet the Australian Overnight Index Swap (OIS) curve now discounts only 19bps of rate cuts over the next year (Chart 14). This mirrors the trend seen in other developed interest rate markets, as investors have shifted to pricing out the dovish policy expectations as global growth starts to improve. Chart 13Weakening Loan Demand, But No Credit Crunch Weakening Loan Demand, But No Credit Crunch Weakening Loan Demand, But No Credit Crunch Chart 14Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. We advise staying strategically overweight Australian government bonds in global fixed income portfolios. Bottom Line: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com     Footnotes 1    Please see BCA Research US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Lowdown On Low-Rated High-Yield The Lowdown On Low-Rated High-Yield Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns